Financial Systems and Income Inequality. Bruges European Economic Research Papers 36/2017

Maldonado, Joana Elisa (2017) Financial Systems and Income Inequality. Bruges European Economic Research Papers 36/2017. [Policy Paper]

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Abstract

This paper examines the impact of financial systems on income inequality. In the debate on ‘real’ effects of financial systems, economic growth has been analysed in detail, while potential welfare effects on income inequality have been widely neglected. Against the background of a trend towards more market-based and less bank-based systems, this paper examines differences between financial systems in terms of income inequality in the European Union. Based on causalities established in existing literature, it is argued that in a more market-based financial systems, stock markets are larger, offering a wider choice and higher yields for high income earners, who have higher shares of their portfolio in stocks, such that income inequality widens compared to a more bank-based financial system. This hypothesis is tested in a panel analysis with a sample of 27 European Union member states from 1995 to 2012. It is found that an increase in the market-based component of a financial system leads to slightly higher income inequality as measured by the Gini coefficient. However, the effect is small and not robust to alternative measurement by the S80/S20 ratio. Decomposing income growth by quintiles does not reveal any influence of changes in the market-based component on inequality. Instead, increases in the bank-based component negatively affect income growth across the income distribution. Yet, the indicative results show that the topic of types of financial systems influencing income inequality might be relevant and deserves attention from both academia and policy-makers. Assessment of the Capital Markets Union project, which introduces a structural reform towards a more market-based financial system in the European Union, should therefore take potential welfare impacts through the income distribution into account.

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