Nº 21-04: Financial Technology and the Inequality Gap

Information-based models of capital income inequality that link return heterogeneity to investor sophistication levels need to assume an increase in data costs to generate an increase in inequality. Empirically, this assumption contradicts the fact that investment markets have become more informative over time, and theoretically, it also overlooks the possibility that poorer investors can avoid paying a large fixed cost for data, simply by buying shares in a fund. In this paper, I study the impact of financial innovation on capital income inequality in a theoretical framework where investors, heterogeneous in their sophistication, have a costly choice between not investing, investing through a fund of average quality, and searching for an informed fund. The model predicts that while financial innovation can make the investment sector more efficient and boost financial inclusion, some financial innovation also brings risks. For example, when the cost of financial data processing falls, more wealthier investors trade on information. This makes participation less valuable for the marginal stock market participant, who is a relatively poorer investor in some average (uninformed) fund and who exits the market altogether, foregoing the equity premium. This amplifies the inequality gap and also jointly explains why in the last decades, in spite of a dramatic reduction in data processing costs and fund fees, the US stock market has become more informative, yet the stock market participation rate has been on the decline.