Abstract:
This paper investigates the relationship between financial development and income inequality by taking the role of individuals' talent into account. We measure talent using the direct observations of individuals’ achievements before entering the labor force by using the Program for International Student Assessment (PISA) scores. We employ the FE, IV-RE, 2SLS and System GMM models to a panel data of 46 developed and developing countries for the period 1998-2012. We also use principal component analysis (PCA) to construct a reliable measure of financial development. The paper finds that financial development is negatively associated with income inequality. The paper also shows that countries with higher PISA scores experience lower income inequality while the marginal effect of financial development on income inequality varies by the level of PISA scores. Moreover, the results do not suggest evidence of nonlinearity between financial development and income inequality.
