Financial Market Policies to Reduce Income Inequality

1 The study employs the Deininger and Squire (1996) set of Gini coefficients for 49 developed and developing countries from 1947-94. It uses five-year averages of these and all explanatory variable data. Previous chapters of this report have emphasized the role of factor prices, and particularly the wages of unskilled workers, as a key determinant of income inequality. Through their impact on family decisions about fertility, labor force participation and education, low wages promote and perpetuate high levels of income inequality. The returns to labor are also importantly affected by the amount of capital with which workers can operate. As economies develop and capital becomes less scarce, the return to labor tends to rise and the return to capital tends to fall, and these changes in factor returns are reflected in lower income inequality. Here is where financial markets come in. Financial markets provide the institutional framework within which savings are mobilized and intermediated to generate the productive investments required to raise workers’ productivity and wages. If financial markets are not functioning effectively, domestic investment will not match its potential, and the scarcity of capital will adversely affect not only prospects for economic growth, but also the distribution of income. But there is more to the story because the scarcity of credit that comes with inadequately functioning financial systems is likely to be particularly severe for small businesses and potential entrepreneurs, whose financial needs may be more expensive to service (as a proportion of the typical loan size) than larger businesses, and whose creditworthiness is more difficult to assess. The severe shortage of credit will restrict the capacity of small businesses and microentrepreneurs to obtain access to the working and physical capital required to raise their productivity and expand their businesses, thus leaving those working in the sector with severely reduced earnings capacity. Finally, inefficient financial systems offer particularly poor terms to small savers who, if located in underserved rural markets, may even be locked out of the opportunity to place their savings in a financial institution. They may therefore be faced with the need to invest in very low-earning or risky assets, such as currency or durable goods. This reduced access of low-income families to deposit and other nonlending services of the financial system may also worsen the distribution of income. Reforms to improve the functioning of the domestic financial system and ensure that it adequately supports productive investments by entrepreneurs and small businesses thus have the potential to improve income distribution, while at the same time promoting economic growth and efficiency. This chapter details the linkages between the operation of financial markets and the distribution of income. It also discusses concrete reforms that could improve the functioning of financial markets, particularly their capacity to support the small enterprise sector in which so many of the region’s low-income wage earners are employed.