Academic journal article Economic Inquiry

Financial Development and Wage Inequality: Theory and Evidence

Academic journal article Economic Inquiry

Financial Development and Wage Inequality: Theory and Evidence

Article excerpt


In recent years, the increase in wage inequality in the United States has received a lot of attention from economists. Researchers have documented the rise since the 1980s in overall wage inequality, differentials between wages of college degree and high school diploma holders (between group inequality), as well as the increase in wage differentials measured within education and experience groups (residual or within-group inequality). (1) The factors usually identified with the increase in wage inequality are trade, changes in labor market institutions, technological progress, and organizational change. In this paper, we study the role of financial development as an independent source of the increase in wage inequality. We consider financial development as a combination of changes in regulatory policy and financial innovation that provided easier access to finance for firms (particularly start-ups). We develop a model that links financial development to wage outcomes, and we test the predictions of the model using state-level data from the United States during the recent period of financial deregulation.

The interaction between entrepreneurial finance, organizational change, and technological progress has become an increasingly important component of the innovation and technology adoption process in the United States in recent decades. Following the 1979 amendment to the Employee Retirement Income Security Act (ERISA), which permitted pension funds to invest in risky asset vehicles such as venture capital, the amount of capital flowing into venture capital firms increased substantially (Gompers and Lerner 2004, chapter 1).

Subsequently, venture capital financing was found to have a positive impact on innovation (Kortum and Lerner 2000). Dynan et al. (2006) document the greater ease with which firms and households can access credit markets in the United States during this period thanks to financial innovation and changes in government policy. Black and Strahan (2002) show that entrepreneurial activity (measured by the rate of new business incorporations) increased following banking deregulation across the United States in the 1980s.

Associated with these developments was a change in organizational form in the U.S. economy. Smaller firms employing workers of similar skill levels rose in prominence, whereas the large-scale corporations that mixed workers of differing skills declined. Kremer and Maskin (1996) document that the correlation between wages of U.S. manufacturing workers in the same plant rose from 0.76 in 1975 to 0.80 in 1986 and argue that this "segregation by skill" contributed to the rise in wage inequality. The coincident timing of these developments suggests that financial development may have facilitated the change in organizational form (and thus the widening of the wage distribution) by promoting the emergence of smaller, innovative start-up firms.

We build on these insights and construct an endogenous growth model with imperfect credit markets. Our model predicts that financial development raises growth by encouraging the entry of new firms. This prediction is in line with the vast evidence on the positive relationship between financial development and growth (Jayaratne and Strahan 1996; Levine 1997) as well as on the positive effect of financial deregulation on firm entry (Black and Strahan 2002). Our contribution is to demonstrate that financial development can also affect labor market outcomes by changing the relative demand for skilled labor. Using our model, we show that financial development may lead to organizational change (in the sense of a reallocation of workers by skill levels across firms), which results in the widening of the wage distribution. Specifically, financial development drives up the skilled/unskilled wage differential (between group inequality) and can also increase within-group inequality.

The second part of the paper confronts these predictions with evidence from the United States. …

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