The relationship between financial development and income inequality: Testing the Financial Kuznets Curve hypothesis

The financial sector, defined as a critical tool for economic growth by bringing together fund supply and demand segments, is a key element that should be emphasized in increasing human and physical investments. However, financial sector development can also affect income inequality, and these effects may change over time. From this perspective, while the implementation of policies is of great importance for the development of countries' financial systems, justice in income distribution must also be observed. Kuznets Hypothesis, which explains the differences in income distribution between economic units, states that income inequality increases in the initial stages of economic growth and decreases after a certain growth point. Income inequality exists in the initial stages of economic growth because resources and income distribution are still within a complex economic structure. As economic growth reaches the middle stage, savings rates increase, but income inequality also increases. As economic growth continues, large segments of society participate in financial markets and income inequality decreases in the process. Greenwood and Jovanic (1990), who adapted the Kuznets Hypothesis, which deals with economic growth and income inequality, to financial market development, developed the Financial Kuznets Hypothesis. According to the Financial Kuznets Hypothesis, there is an 'inverted U' shaped relationship between financial development and income inequality. This is because income inequality increases in the initial stages of financial development, and after a certain threshold, income inequality decreases. In the initial stages of financial development, financial infrastructure inadequacies, information asymmetry and the cost of inclusion in the financial system allow only those above a certain income level to benefit from financial developments, and this causes income inequality to increase. When financial development exceeds a certain threshold value, entrepreneurial activities and financial product diversity increase as a result of financial accessibility, while financial market disruptions and credit restrictions decrease, allowing every segment of society to benefit from financial developments. Therefore, income inequality begins to decrease. The aim of this study is to test the validity of the Financial Kuznets Curve hypothesis for OECD countries, based on the relationship between financial development and income inequality. For the purpose of the study, the Flexible Generalized Least Squares Method was applied to annual data between 2002 and 2019, using the the Gini index as an indicator of income inequality, the M2 money supply as an indicator of financial development as an independent variable, the square of the M2 money supply in order to see the course of the Financial Kuznets Curve, and public expenditures, GDP growth rate and population growth rate as control variables. The findings show that income inequality decreases in the early stages of financial development in the OECD countries covered in the study, but after a certain threshold level is exceeded, income inequality increases. Accordingly, there is a 'U' shaped relationship between financial development and income inequality. In addition, the GDP growth rate and public expenditures have a decreasing effect on income inequality, while the population growth rate has an increasing effect. Keywords: Financial development, income distribution, panel data analysis.