The Nonlinear Effect of Financial Development on Income Inequality: New Evidence from a Multi-Dimensional Analysis

Over the past three decades, rising income inequality has undermined economic performance and posed challenges for policymakers, highlighting the need to identify its underlying drivers to design effective policy responses. Financial development is often considered a potential driver of inequality, yet the theoretical and empirical literature on how financial development affects inequality remains inconclusive. Moreover, prior studies have primarily relied on traditional indicators, which do not comprehensively reflect the multidimensional nature of financial development. To address these gaps, we provide the first study to employ the IMF’s Financial Development Index and all its sub-indices within both fixed-effects and system GMM frameworks to examine whether financial development and its dimensions exhibit a nonlinear relationship with income inequality. Unlike traditional indicators, these indices offer a more comprehensive view of financial development. Using panel data for 130 countries from 1980 to 2019, we find that financial development and its dimensions—access to financial institutions (financial inclusion) and depth of financial institutions—initially reduce inequality but exacerbate it once their respective thresholds are exceeded. These results are not driven by systemic banking crises. Our study contributes by providing a more comprehensive assessment, demonstrating nonlinear effects, identifying thresholds, and offering policy implications for countries at different income levels.