This paper focuses on the relationship between income inequality and state capacity in South Korea. Korea achieved rapid economic growth accompanied by equity from the 1960s to the mid 1990s. However, after the 1997 IMF financial crisis, income inequality in Korea increased dramatically. This change in income inequality is closely related to increases in unemployment and underemployment. I argue that such failures in the labor market are attributed to the rapid decline of the state's capacity after financial liberalization in 1993. During the developmental era, the state had been able to form institutions for low income inequality, due to its relative autonomy from business owners. After the financial liberalization no such autonomous capacity to build employment-protective institutions existed, as these reforms increased the influence of domestic and international capital. Further, the weakening of the state's capacity also reflects changes in the relationship of the Korean economy to the world system.