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Financial Inclusion and Income Inequality

Introduction

Financial inclusion is important in improving economic growth by reducing income inequalities. Economists agree that reducing income inequality increases disposable income among the poor, which is a primary demand. Governments have attempted various strategies to tackle the issue over time. Income distribution through financial institutions has been given prominent attention by policy developers. Financial institutions play a critical role in income distribution. Economic growth depends on how various industries access capital allocated by financial markets. The World Bank defines financial inclusion to mean access to affordable and usable products that meet businesses and individuals’ financial needs (Mader, 2018). Financial inclusion is also about delivering financial products responsibly and sustainably.

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The reduction of income inequality for governments is important for various reasons. Income inequality affects the economy in various ways that reduce economic growth. It provides some incentive for basic economic activities (Tita and Aziakpono, 2017). However, high levels of income inequality are associated with underinvestment in human capital, cause social instability, and prevent social mobility. High-income inequalities are closely correlated with shorter economic growth spells that are below average. Financial theory suggests that financial institutions and markets allocate resources efficiently to reduce income inequality without information asymmetry and imperfections of the market (Park and Shin, 2017). Financial inclusion allows capital flow across firms and households, generating high levels of economic growth. When some firms are excluded from the financial sector, the result is unequal growth that is unsustainable in the long run.

Governments have attempted various interventions to reduce income inequality. One of the fiscal strategies is the use of progressive taxation. Progressive taxation involves increasing taxation for higher incomes. The aim is to tax the rich more and channel the increased revenues to programs for reducing poverty. Income inequality programs include welfare programs that are meant to improve the livelihoods of the poor. However, the fiscal strategies are counterproductive and tend to discourage high incomes. Businesses dependent on profits suffer more under progressive taxation and are likely to relocate to other countries with better taxation policies. Governments have also invested in education as a method for reducing inequalities.

This brief’s purpose is to analyze the relationship between inclusion income inequalities and inclusion in financial markets. The analysis examines the causal relationship between the two variables. The paper assumes that a reduction inequality is the desired because of its economic advantages. A causal relationship between income inequality and financial inclusion would inform policymakers on potential strategies for reducing income inequality. The brief will analyze literature and existing data on the two variables to understand their relationship’s nature. The aim is to conclude the analysis that could inform future policy options.

  • The paper will answer the following research questions?
  • Does increase in financial inclusion assist to reduce income inequality?
  • Can financial inclusion be used as a policy strategy of reducing income inequality?

Literature Review in USA

Studies in the USA have focused on the theoretical and empirical aspects of financial inclusion and how it relates to income inequalities. According to Tita and Aziakpono (2017), initial theoretical finance models implied that financial development enhanced equality relative to some financial obstacles. In theory, some of the financial impediments to financial development included information asymmetry, transaction costs that excluded some society members from access to financial services. Notably, the lack of collateral among the poor and poor credit histories prevented the poor from accessing financial services. The policy recommendation was to reduce the limitations that prevented the poor from access to financial products to reduce income inequalities.

Some other models predicted that there was a nonlinear relationship inequality and financial inclusion. The distributional effects of inclusion in financial markets affect inequality depending on some other variables (Tita and Aziakpono, 2017). For instance, the models predicted that only wealth is included in financial markets at lower economic development levels. In the lower levels of economic development, financial inclusion can have significant effects on income inequalities. The models explain that at lower levels of economic development, there are untapped resources activated by financial inclusion contributing to reduced income inequalities. However, at higher levels of economic development, there are no uniformed people or underutilized resources. In these cases, improved financial inclusion may not be translated into reduced income inequalities. Such models imply that regression analysis may not yield meaningful results. Park and Shin (2017) reported that other theoretical models had challenged the nonlinear relationship arguing that the effects of financial inclusion don’t only depend on underutilized resources. Finance fuels economic growth regardless of the level of development within the economy. In some instances, theoretical models have analyzed the possibility of a reverse causal relationship with reducing income inequality and increasing financial inclusion. This implies that policymakers should not focus on financial inclusion to reduce inequality in society (Mader, 2018). However, such theories defy basic macro-economic theory on aggregate demand and financial institutions’ role in the economy.

The lack of conclusion on the nature of causation between the two variables, in theory, is compensated by empirical evidence. Tita and Aziakpono (2017) provided empirical evidence of a strong relationship between distribution of income in the USA and inclusion in the financial markets. According to Park and Shin (2017), various studies done in the USA have established that increased financial inclusion disproportionately increases the poor’s incomes, hence reducing income inequality. In other words, improved financial inclusion boosts the poor’s lives more than those of the rich. Further, empirical findings have established that eliminating financial markets obstacles has a more significant impact in reducing income inequality than other redistributive strategies. According to Park and Shin (2017), a study of 22 countries in sub-Saharan Africa found that the financial sector’s development between 1990 and 2004 led to improved financial inclusion and hence reduced income inequalities.

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Other empirical studies could be grouped as attempting to find out how financial inclusion affects income inequality. For example, Omojolaibi (2017) reports studies that have established that financial inclusion reduces income inequality indirectly by engaging more poor people in the labor markets. A study of the effect of commercial bank deregulation in the USA found that it not only improved financial inclusion but also reduced income inequality by improving conditions in the labor market (Omojolaibi, 2017). Another study in Thailand found that including more people in financial markets has the same positive impact in inequality like in the USA. The findings confirm that there is an inverse relationship between the two variables under review.

Data and Methodology

The empirical study tests how the various financial inclusions’ attributes influence income inequality across different 122 countries as presented in the Omojolaibi (2017) research. This comparison across countries is meaningful because different countries are in different categories of income. The objective is to find the linear relationship between inclusion in financial markets and income inequality by analyzing cross-sectional data for different countries. In this case, income inequality is the dependent variable (Y), and the independent variable (X) is financial inclusion. The guiding regression equation would be:

Y=a+bXi+cXii

Where; Y=income inequality

a =exogenous factors that affect income inequality

Xi=Account Savings

Xii=Borrowing as a measure of financial inclusion

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b ,c=Coefficients to be determined by the regression equation.

The study will depend on secondary data from previous studies done on the topic. Similar regression equations have been done in various studies, but the brief will isolate the data and run a regression to identify the effects on the two variables. The study collects data on the aspects of the two variables to determine how to cross-country data supports the hypothesis that improved inclusion in financial markets reduces inequality. The Gini Coefficient of disposable income measures the independent variable is given as a percentage. A Gini Coefficient of 0 implies a situation of perfect equality while that of 100 depicts a condition of perfect inequality.

The study uses data for 122 countries in different economic categories available in various World recognized databases (Omojolaibi, 2017). The brief assumes that some factors such as growth, trade, education, and other redistributive policies are endogenous and hence are controlled (Omojolaibi, 2017). For example, the increases in economic growth can reduce income inequality without the effects of financial inclusion. The data is based on the World Bank categorization of countries depending on their incomes in 2015 (Park and Shin, 2017). The control variables should be manipulated so that their effects are not assumed to affect financial inclusion.

The dependent variable of income inequality is easy to measure than understanding the causes of change between countries over time. The Gini Coefficient is objective and groups populations against income. However, many other variables could influence changes in the level of inequalities over time. The control variables will assist in eliminating some of the effects of endogenous factors. Two factors are used to measure financial inclusion in this case. The percentage of people owning bank account measures financial inclusion requiring the facilitation of transactions and savings. Borrowing is the second aspect of financial inclusion that measures access to credit. The two factors contribute towards income inequality reduction simultaneously. The savings accounts indicate the accumulation of funds available for lending. People must save as a society before banks can have enough funds to lend and stimulate economic growth. The percentage of people with accounts in a financial institution is used to measure the accounts variable.

Results

Variable Inequality 10% Quartile Inequality 25% quartile Inequality 50% quartile Inequality 75% quartile
Account b -0.07 -0.08 -0.1 -0.07
Borrowing c -0.4 -0.6 -0.4 -0.3

Table 1: Income inequality regression results (Omojolaibi, 2017). (Omojolaibi, 2017).

The results show the regression analysis for financial inclusion and inequality in income for various countries within different income groups. The Gini coefficients for countries are objective measures for inequalities in income. Borrowing is also measured as a percentage of people with access to credit facilities from a financial institution. The negative signs of the coefficients confirm the inverse relationship between financial inclusion and level of income inequality. At all levels of income, the increase in financial inclusion reduces inequality in society. Further, the results show that account ownership reduces inequality at all levels, but the reduction is more in countries with high income inequalities. The confidence tests result for account ownership was P=0.008, indicating we should reject the null hypothesis the regression coefficients are equal for all quartiles.

The negative signs on the borrowing factor indicate an inverse relationship between inequality and financial inclusion. As the number of people accessing credit from financial institutions increases, income inequality is lowered. The sign remains harmful for all quartiles but increases significantly in higher quartiles of inequality, indicating that the effect of borrowing is higher in high levels of income inequality. Further, the P result for the equality test is 0.296 indicating all the quartile regression coefficients are not equal (Tita and Aziakpono, 2017). The findings show that for all quartiles economic inclusion is related with a significant reduction in inequalities. As the level of inequality increases, the impact of financial inclusion is more.

There are various justifications for the above results. Borrowing increases aggregate demand which the multiplier effect increases to increase incomes. People borrow to consume products within the economy, increasing demand for end products, hence the demand for labor. As more employment opportunities are created, more people are employed, hence earning more income. On the other hand, businesses borrow to expand their operations and capacities, which increase employment opportunities. More people are yet to get income sources at high levels of income inequality and operate in the informal sector. At these levels of income inequality, financial inclusion has a higher impact subject to the law of increasing returns (Park and Shin, 2017). Account ownership measures the percentage of people in the formal sector. It also measures the resources that the financial sector can mobilize towards financing economic activities. The effect of financial inclusion is across all income levels, and there is no limit to it as a tool for reducing income inequality. Financial inclusion tends to vary across countries within different income levels, but the relationship remains inversely linear.

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Conclusions and Policy Recommendations

The brief analyzes the relationship between inclusion in financial markets and cross-country income inequalities. Two important conclusions can be drawn from the foregoing analysis. One, account ownership and borrowing are critical drivers of reducing income inequality for all countries. Two, monetary inclusion has positive impacts on reducing inequalities in income depends on the country’s poverty levels and distribution of income. The outcome of the study has essential additions to the existing literature on the relationship between distribution of income and financial markets. The results are well aligned with some of the theoretical models and most of the existing empirical findings. The findings support the models that predict an inverse linear relationship between the two variables. In line with macroeconomic theory, it would be expected that high levels of inequality are a sign of untapped potential, which is released by efficient allocation of financial resources. The findings do not explain the direct and indirect mechanisms through which financial inclusion reduces income inequality. For instance, it is impossible to understand how much of the borrowing population increases production capacity or is consumed by end products.

The findings have various practical implications on policy. One, governments can use the financial sector to reduce income inequality and stimulate economic growth. Financial institutions focused on reducing income inequality should aim at improving financial inclusion. This is because financial inclusion stimulates aggregate demand through the multiplier effect. Therefore, governments should work with financial institutions to identify and eliminate the factors limiting financial services’ access. For example, lack of financial education and poor infrastructure could prevent financial institutions from investing in some regions. Secondly, inclusion in financial markets can only be effective in reducing income inequality if it entails increased access and utilization of financial services. For instance, account ownership represents a measure for formal financial services access while borrowing implies increased financial services usage. Third, governments must actively provide a good business environment or the effects of inclusion to be felt by all. This could be done by improving the ease of doing business, strong legal systems protecting property rights and availability of skilled labor.

The effect of financial inclusion in overcoming income inequality depends on the government’s ability to create an enabling environment. This entails connecting the necessary infrastructure that supports growth. A well interconnected company allows financial institutions to establish branches that end up including more people in the financial sector. Communication interconnectivity implies that the benefits of financial inclusion could be shared by all people including the poor. Education and financial literacy is another aspect that influences the degree of the spread of the benefits of financial inclusion. It means that financial inclusion policies cannot work in isolation. Financial inclusion policies should be used alongside fiscal policies to address the challenge of inequality in income. Policy efforts should first establish an enabling environment before using the financial inclusion policies.

Reference List

Mader, P. (2018) ‘Contesting financial inclusion’, Development and Change, 49(2), pp. 461-483. Web.

Omojolaibi, J. A. (2017) ‘Financial inclusion, governance and economic progress in Nigeria: what happens to the welfare of the poor?’, Oman Chapter of Arabian Journal of Business and Management Review, 34(93), pp.1-14. Web.

Park, D. and Shin, K. (2017) ‘Economic growth, financial development, and income inequality’, Emerging Markets Finance and Trade, 53(12), pp. 2794-2825. Web.

Tita, A. F. and Aziakpono, M. J. (2017) ‘The relationship between financial inclusion and income inequality in sub-Saharan Africa: evidence from disaggregated data’, African Review of Economics and Finance, 9(2), pp. 30-65. Web.

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StudyCorgi. (2022, September 18). Financial Inclusion and Income Inequality. Retrieved from https://studycorgi.com/financial-inclusion-and-income-inequality/

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