Capital Controls and Income Inequality

We examine the implications of capital flows and capital account policy for income distribution in a small open economy with heterogeneous agents and financial frictions. Banks engage in costly intermediation between household savings and entrepreneur investment. Our model predicts that inflow surges disproportionately raise entrepreneur income, exacerbating inequality, while transitory increases in outflows reduce inequality. Instrumental variable estimation with a panel of gross and net private capital flows for 87 emerging market economies provides robust support for the model’s predictions. We further show that, under capital-skill complementarity, capital account liberalization that induces net capital inflows raises both the skill wage premium and overall income inequality.