Do you want to reduce income inequalities through access to start-up capital?

The gap between economic theory and practice is sometimes cavernous. According to one theory, developed financial markets and access to lenders should make it easier for people to borrow money, become entrepreneurs, and move up to higher income brackets. But new search in the Journal of Policy Modeling notes that, in practice in the United States, income inequality increases as financial markets develop.

“We find that financial development positively affects income inequality,” the authors write. “A linear relationship exists in 50 US states between financial development and income inequality.”

Many studies that examine the consequences of financial development compare data across countries. But cultural and political differences that are difficult to measure can sometimes skew the results. Looking across states in the United States, these differences can be minimized, explains Stephen miller, director of the Center for Business and Economic Research at the University of Nevada, Las Vegas and one of the authors of the article.

As an indicator of financial development, the authors use a ratio between stock market wealth per capita and personal income per capita, neither corrected for inflation. Market wealth refers to the financial wealth of households measured by assets such as company stocks, pension fund reserves, and mutual funds. The ratio is “an approximation trying to capture” some measure of access to capital, Miller says.

To measure income inequality, they look at three measures – the Gini coefficient, a widely used measure of household inequality and the share of the population in the richest 10% and 1% of income. The data spans five decades, from 1976 to 2011.

Kuznets inversion

Again, the relationship between financial development and the income inequality the authors find is linear. Visually, the relationship looks like a line. Plotting the data for all 50 states would produce a graph that looks like this:

Linearity. For illustrative purposes. (Clark Merrefield)

It is important to note that the authors of this article examine trends over decades in a specific time period in an advanced economy. The linear relationship they find runs counter to the Kuznets curve, which is based on a long-held assumption that economist Simon Kuznets developed over half a century ago.

The Kuznets curve is an inverted U shape that demonstrates the Kuznets hypothesis on the relationship between economic growth and income inequality. It shows how income inequalities change as economies move from agriculture, to industry, to post-industrial. It looks something like this:

The shape of a Kuznets. (Clark Merrefield)

Kuznets hypothesized that as economic markets develop, inequality increases but later decreases. Indeed, in less developed economies, fewer people have initial access to capital. Most people may be farmers, for example, and not live near cities where finance thrives. But as an economy industrializes, more and more people have access to capital to start a business. Wages are rising and inequalities are falling.

“The early stages of development and growth lead to inequality, but the economy, when it continues to grow, eventually reduces inequality,” says Miller, explaining the Kuznets curve. “So the idea is this: don’t worry about inequalities, you have to start the growth process. But, eventually, he will turn around and have some correction. “

A different relationship between financial development and inequality emerged when the authors explored and divided the country into states with income inequality and those with lower than average inequalities. The Kuznets curve appeared for states with below-average inequalities. But states with above-average inequality had a U-shaped curve. Income inequality declined as financial markets developed, and then increased as those markets matured. For states above average, the curve looks like this:

An inverted Kuznets. For illustrative purposes. (Clark Merrefield)

It matters where states leave

These different relationships could have to do with extensive and intensive margins, according to the authors. Large margins relate to whether the poor have access to or use financial markets. They describe the extent to which people have access to capital – a measure of quantity. Intensive margins focus on the behavior of wealthy people who are already using financial products. They describe the intensity with which people use the financial markets – a measure of the degree. The authors explain that “the benefits of improving the quality of the financial system can disproportionately flow to the rich, which tends to increase income inequality”.

For states that start with below-average inequality – states with a relatively small gap between highest and lowest incomes – the rich tend to initially benefit from a growing and improving financial market. The poor see the benefits later. This is the Kuznets curve.

But poor people generally appear to benefit from financial development upfront in states with above-average inequality, according to this new research. In the long run, however, the rich benefit more from continuous improvements in the financial system. While the authors do not analyze outliers, a small number of anomalies among the above-average states – for example, a handful with particularly large income inequality gaps – might explain why this group reverses the gap. Kuznets curve, says Miller.

“It’s pure speculation on my part,” he adds.

Governments can aim to reduce income inequalities by helping the poor to access financial markets. Whether a state starts more or less on an equal footing could make a difference in whether this access helps reduce income inequality.

“Whether such policies actually reduce or increase inequality depends on the individual characteristics that determine whether a state experiences above-average or below-average inequality in the first place,” the authors write. “Our results suggest that such policies are more likely to achieve expected results in below-average states of inequality.

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