Beyond the Threshold: Nonlinear Effects of Financial Development on Income Inequality in Emerging Economies

Abstract This study examines the dynamic relationship between financial development and income inequality, with particular emphasis on the threshold effects of financial development on income inequality and the direction of causality between the two variables. Using a balanced panel of 17 emerging economies over the period 1990 to 2020, the study applies the bias-corrected dynamic panel approach of Breitung et al. (2022), the dynamic panel threshold model of Seo and Shin (2016), and panel causality analysis. The findings reveal a significant long-run negative relationship between financial development and income inequality, supporting the inequality-narrowing hypothesis. The threshold analysis identifies a significant threshold of 30.284%, below which financial development increases income inequality and above which it significantly reduces inequality, confirming an inverted U-shaped relationship. The causality results further indicate a significant relationship between financial development and income inequality. These findings suggest that financial deepening alone may not ensure inclusive development. Emerging economies should strengthen financial inclusion, institutional quality, and equitable access to credit and financial services, particularly during the early stages of financial development. The study contributes to the finance and inequality literature by identifying a critical financial development threshold and demonstrating that the distributional effects of financial development vary according to its level.