Capital Controls and Income Inequality

Abstract

We examine the distributional implications of capital account policy in a small open economy model with heterogeneous agents and financial frictions. Households save through deposits in both domestic and foreign banks. Entrepreneurs finance investment with borrowed funds from domestic banks and foreign investors. Domestic banks engage in costly intermediation of deposits from households and loans to entrepreneurs. Government capital account policy consists of taxes on outflows and inflows. Given policy, a temporary decline in the world interest rate leads to a surge in inflows, benefiting entrepreneurs and hurting households. Raising inflow taxes or reducing outflow taxes mitigate this redistribution. However, in the long run liberalization of either inflows or outflows reduces inequality. The model's short-run implications are supported by empirical evidence. Based on instrumental variable estimation with a panel of emerging market economies, we demonstrate that increases in private capital inflows raise income inequality, while increases in outflows reduce it. These effects are significant and robust to a wide variety of empirical specifications.