Income Inequality and Frontend Innovation: Evidence from Frontier Markets

The lack of innovation hurts small firm access to resources for expansion in frontier markets. This incidence has implications for economic growth and therefore income inequality. Despite an emerging view that front-end innovation (FEI) is critical for small firm's access to credit, the relationship between FEI and inequality especially in the context of frontier markets is little studied in the empirical literature. To close this gap, this paper contributes to the literature on income inequality, by extending existing models to examine the effect of FEI on income inequality. We use a fixed effect panel regression on annual country-level data for thirty-one frontier markets, over a 15-year (2003-2018) period, and find an insignificant correlation between income inequality and FEI. The instrumental variable estimates, however, show a significant association between both measures of FEI and income inequality. Our instrumentation strategy and robustness checks suggest that this correlation partly reflects a causality from FEI to Inequality: for instance, when measured by education expenditure, a 1% change in FEI increases inequality by 0.234%. When measured by gross value added, a 1% change in FEI reduces income inequality on average by 0.105%. Overall, our findings confirm that FEI is a significant determinant of increases in entrepreneurial income share.