Does Capital Account Liberalization Affect Income Inequality?*
| Author | Dan Su,Xiang Li |
| DOI | http://doi.org/10.1111/obes.12405 |
| Date | 01 April 2021 |
| Published date | 01 April 2021 |
377
©2020 TheAuthors. OxfordBulletin of Economics and Statistics published by Oxford University and John Wiley & Sons Ltd.
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OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 83, 2 (2021) 0305–9049
doi: 10.1111/obes.12405
Does Capital Account LiberalizationAffect Income
Inequality?*
Xiang Li†, ‡ and Dan Su§
†Halle Institute for Economic Research, Kleine Maekerstrasse 8, Halle (Saale), 06108,
Germany (e-mail: xiang.li@iwh-halle.de)
‡Martin Luther University Halle-Wittenberg, Universitaetsplatz 10, Halle (Saale), 06108,
Germany (e-mail: xiang.li@iwh-halle.de)
§University of Minnesota, 321 19th Ave S, Minneapolis, Minnesota 55455, USA
(e-mail: suxxx478@umn.edu)
Abstract
By adopting an identification strategy of difference-in-differenceestimation combined with
propensity score matching between liberalized and closed countries, this paper provides
robust evidence that opening the capital account is associated with an increase in income
inequality in developing countries. Specifically, capital account liberalization, in the long
run, is associated with a reduction in the income share of the poorest half by 2.66–3.79%
points and an increase in that of the richest 10% by 5.19–8.76% points. Moreover,directions
and categories of capital account liberalization matter.The relationship is more pronounced
when liberalizing inward and equity capital flows.
I. Introduction
For policymakers worldwide, one of the top concerns is the current debate on how and to
what extent a country,especially a developing country, should liberalize its capital account.
Therefore, a clear understanding of the related impacts is essential. Specifically,capital ac-
count liberalization is the external aspect of financial liberalization and indicates policies
that are designed to reduce the constraints of cross-border capital flows into or from for-
eign economies. Compared with the large body of studies investigating the consequences
of capital account liberalization for economic growth and financial instability,works on its
distributional consequences are much less common. In recent decades, a simultaneous in-
crease in income inequality and capital account liberalization has emerged as a significant
phenomenon. A first glance at the trends of capital account openness and income inequality
suggests a positive correlation. Figure 1 shows that income inequality developed in tan-
dem with capital account openness during the period 1970–2015.1However, the theoretical
JEL Classification numbers: F38; D63.
*We thank the Editor, James Fenske, and three anonymous referees for useful comments and suggestions. Open
access funding enabled and organized by Projekt DEAL.
[Correction added on 9th October 2020, after first online publication: Projekt Deal funding statement has been added.]
1The correlation coefficient between the Gini coefficient and the Chinn-Ito capital account openness measure is
0.86, and it is statistically significant with a P-value of less than 0.001.
378 Bulletin
(a)
(b)
Figure 1. Time series of gini coefficient and capital account openness by country groups
Notes: The Gini coefficient is from the EHII database. The OECD countries here does not include Lithuania
which became a member in 2018.
hypothesis on the relationship is ambiguous, and much empirical work needs to be
done.
This study investigates the relationship between capital account liberalization and in-
come inequality. Specifically, it assesses whether and how domestic income inequality
changes with the liberalization of cross-border capital flows. Hence, this study focuses
on inequality within rather than between countries even though global inequality (i.e.
worldwide income distribution) is important.2The key findings are threefold. First, capital
account liberalization is associated with an increase in income inequality in developing
countries; however, the relationship is insignificant for developed economies. Moreover,
the association is stronger over the long term than over the short term: opening the capital
account is associated with a short-term rise of 0.07–0.30 standard deviations in the overall
Gini coefficient and as large as 0.32–0.62 standard deviations over the following 10years.
Second, the increase in income inequality is attributable to the considerableincrease in the
income share of the rich groups and the decrease in that of the poor groups after capital
account liberalization. The magnitude of increase in the income share of rich groups is
higher than the decrease seen among the poor groups: there is a decrease in the income
2Our choice of focus is based on two reasons.The first pertains to the difficulty of constructing a global inequality
index from representative worldwide income data and the second is that we are interested to see whether there are
different findings of capital account liberalization with respect to heterogeneity among countries.
©2020 The Authors. Oxford Bulletin of Economics and Statistics published by Oxford University and JohnWiley & Sons Ltd.
Capital account liberalization and income inequality 379
share of the poorest half by 2.66–3.79% points and an increase in that of the richest 10%
by 5.19-8.76% points over the long term. Third, in terms of the different dimensions of
capital account liberalization, we find that both directions and categories are significant.
The strong association with increased income inequality arises mainly from inward capital
account liberalization rather than from outward liberalization; moreover, the relationship
is the most pronounced in the liberalization of the international equity market while liber-
alizing foreign direct investment (FDI) showsa much smaller and statistically insignificant
relationship with income inequality.All of these findings do not depend on the selection of
specific indicators of capital account liberalization or income inequality. We demonstrate
the robustness of our findings by using Gini coefficients and income shares from other
databases and other capital account liberalization indicators, and the results do not change
qualitatively and are quantitatively even stronger in some specifications.
This study makes four substantive contributions to the literature that links external
financial liberalization to income inequality. First, we provide evidence of an association
between opening the capital account and the income shares of different income groups.
Previous studies have largely used the nationwide Gini index as the dependent variable,
and thus the use of income share data in this study not only provides overall distributional
results but also captures which group changes the most. Second, we construct a new capital
account liberalization index based on existing ones and identify exact liberalizing years
for each country based on various capital account openness indicators. By regressing
on the other capital account openness indicators, we extend the data of Fern´andez et al.
(2016), including granular data for different directions and categories of capital account
liberalization. Next, we date the exact liberalizing year for each country and construct
a dataset that complements a difference-in-difference (DID) analysis. Specifically, the
liberalizing year is identified when there is a substantial change in the average degree of
capital account openness in the 10 years before and after, especially when the average
openness value changes from negative to positive. Third, we employ the DID approach
combined with propensity score matching (PSM) to estimate the relationship between
opening the capital account and income inequality within a 20-year window. Thus, we
mitigate endogeneity concerns of conventional panel fixed effects models, as the DID
method aims to construct a quasi-experiment by selecting two groups of similar countries
and randomly liberalizing the capital account of the treated group while keeping that of the
control group closed. Thus, we can cautiously interpret the findings of this study one step
closer to causality. Fourth, we distinguish between the heterogeneous results of various
dimensions of capital account liberalization, which can help narrow the discussion on
specific opening policies.
The rest of this paper is organized as follows. Section II reviews the relevant literature.
Section III describes the data and variables. Section IV describes the two empirical model
specifications. Section V presents the estimation results. Section VI concludes.
II. Literature review
The interaction between finance and income distribution is necessary to understand the eco-
nomic impacts of financial policies and manage the social tensions of inequality. Building
on the literature, we first define three nested key terms: financial development, financial
©2020 The Authors. Oxford Bulletin of Economics and Statistics published by Oxford University and JohnWiley & Sons Ltd.
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