Why does the nexus between finance and income inequality break in times of financialisation? Empirical evidence for the European Union countries

Abstract

Purpose This paper aims to contribute to the current debate between the mainstream and the non-mainstream literature on the effect of the growth of finance on the level of income inequality, for which the empirical evidence has also been providing mixed results. Design/methodology/approach We estimate a linear model and a non-linear model by employing a panel autoregressive distributed lag approach and relying on the dynamic fixed-effects estimator because of the existence of variables that are stationary in levels and stationary in the first differences. Findings Our findings confirm that finance, economic growth, educational attainment and degree of trade openness have a positive long-term effect on the level of income inequality in the European Union countries, whilst government spending has a negative impact in the short term. Research limitations/implications Our findings imply that policy makers should rethink the functioning of the financial system in order to restore a supportive relationship between finance and income inequality and adopt public policies that are more in favour of the poor in order to constrain the growth of income inequality in the European Union countries. Originality/value To the best of our knowledge, this is the first paper that, simultaneously, focuses on the European Union countries, assesses the nexus between finance and income inequality, uses three different variables as proxies for the level of income inequality (the Gini coefficient, the top 1% income share and the top 10% income share), measures the variables that are proxies for the level of income inequality in terms of pre-tax and pre-transfer values and as post-tax and post-transfer values, takes into account four different variables as proxies for the role of finance (credit, credit-to-deposit ratio, liquid liabilities and stock market capitalisation) and identifies the long-term and short-term determinants of income inequality.