Inequality, current account imbalances, and middle incomes

Abstract

This paper investigates the complex relationship between current account balance and income inequality, specifically emphasizing the potential sources of nonlinearities. Based on a dataset for 52 developed and developing countries over the period 1990-2019, we first show a one-standard-deviation increase in various income-inequality indicators generates a decrease in the ratio of current account to GDP by -0.5 to -0.9 percentage points in developed countries, but has a weaker impact when the sample is expanded to include emerging and developing countries. We then show those average impacts are distorted along the distribution of economic and financial development variables. The negative impact of income inequality on current account is actually strongly conditioned to the size of financial markets and the degree of financial liberalization. For those countries displaying low GDP per capita or low levels of financial liberalization, additional income inequality seems to improve the current account balance. In addition, the decrease in the current account balance is in most cases from 1.1 to 1.9 times more important in the median country when the increase in inequality is driven by the income of top earners relative to the middle class rather than by the increase in top earners' incomes at the expense of the lowest percentiles of the distribution. These results are robust to various checks for endogeneity concerns, as well as to alternative specifications, samples, and variable definitions.