Financial development and income inequality in developing countries: The role of institutions and regional variation

Income inequality remains a major challenge for developing economies, raising concerns about whether financial development contributes to inclusive growth or instead reinforces existing disparities. Despite the rapid expansion of financial systems in many emerging and developing countries, the distributional consequences of financial deepening remain widely debated in the literature. This study investigates the impact of financial development on income inequality in a panel of 125 developing countries over the period 2002-2022. Using the IMF Financial Development Index and a dynamic panel GMM estimator, the analysis accounts for persistence in income inequality and potential endogeneity between financial development and macroeconomic variables. The results indicate that financial development is associated with higher income inequality, suggesting that financial deepening may disproportionately benefit higher-income groups in many developing economies. The findings further show that political stability and regulatory quality weaken the inequality-enhancing effect of financial development, while government effectiveness exerts a direct inequality-reducing effect rather than a significant moderating influence. Additional results reveal regional variations, with stronger inequality effects observed in Sub-Saharan Africa, Latin America, and the Middle East and North Africa. Among the control variables, economic growth, government expenditure, capital formation, and remittances are found to reduce income inequality, while inflation, population growth, and official development assistance tend to exacerbate income disparities. Overall, the findings suggest that financial development alone does not guarantee inclusive growth and that strong institutional frameworks and supportive economic policies are essential to ensure that financial deepening contributes to more equitable income distribution in developing economies.