This paper provides evidence on the link between financial development and income distribution. Several dimensions of financial development are considered: financial access, efficiency, stability, and liberalization. Each aspect is represented by two indicators: one related to financial institutions, and the other to financial markets. Using a sample of 143 countries from 1961 to 2011, the paper finds that four of the five dimensions of financial development can significantly reduce income inequality and poverty, except financial liberalization, which tends to exacerbate them. Also, banking sector development tends to provide a more significant impact on changing income distribution than stock market development. Together, these findings are consistent with the view that macroeconomic stability and reforms that strengthen creditor rights, contract enforcement, and financial institution regulation are needed to ensure that financial development and liberalization fully support the reduction of poverty and income equality.

The beneficial role of financial development in economic growth has been well documented; however, the literature on the nexus of financial development and income distribution is still nascent. Theories on the effect of financial development on income distribution offer conflicting predictions: one strand of the literature proposes an inverted-U relationship between finance and income inequality, while the other predicts a linear relationship. Greenwood and Jovanovic (1990) predict a nonlinear relationship between finance and inequality, wherein the distributional effect of financial development depends on the level of economic development. At early stages of development, only the rich can access financial services because of the fixed cost of joining the financial coalition, resulting in wider income inequality. As the economy develops, the financial system becomes more accessible and affordable to the poor because human capital replaces physical capital as the main driver of growth.

Galor and Zeira (1993) and Galor and Moav (2004) posit a linear relationship between financial development and income distribution. They suggest that financial deepening eases credit constraints, which benefits low-income groups through the channels of human capital and capital accumulation.