Income Inequality And Asset Prices Under Redistributive Taxation

Lubos Pastor

University of Chicago – Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Pietro Veronesi

University of Chicago – Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

October 15, 2015

Abstract:

We develop a simple general equilibrium model with heterogeneous agents, incomplete financial markets, and redistributive taxation. Agents differ in both skill and risk aversion. In equilibrium, agents become entrepreneurs if their skill is sufficiently high or risk aversion sufficiently low. Under heavier taxation, entrepreneurs are more skilled and less risk-averse, on average. Through these selection effects, the tax rate is positively related to aggregate productivity and negatively related to the expected stock market return. Both income inequality and the level of stock prices initially increase but eventually decrease with the tax rate. Investment risk, stock market participation, and skill heterogeneity all contribute to inequality. Cross-country empirical evidence largely supports the model’s predictions.

Income Inequality And Asset Prices Under Redistributive Taxation – Introduction

In recent decades, income inequality has grown in most developed countries, triggering widespread calls for more income redistribution. Yet the effects of redistribution on inequality are not fully understood. We analyze these effects through the lens of a simple model with heterogeneous agents and incomplete markets. We find that redistribution affects inequality not only directly, by transferring wealth, but also indirectly through selection, by changing the composition of agents who take on investment risk. Through the same selection mechanism, redistribution affects aggregate productivity and asset prices.

Income inequality has been analyzed extensively in labor economics, with a primary focus on wage inequality. While wages are clearly the main source of income for most households, substantial income also derives from business ownership and investments in financial markets, whose size has grown alongside inequality. We examine the channels through which financial markets and business ownership affect inequality. To emphasize those channels, we develop a model in which agents earn no wages; instead, they earn business income, capital income, and tax-financed pensions. In our model, investment risk and differences in financial market participation are the principal drivers of income inequality.

Our model features agents heterogeneous in both skill and risk aversion. Agents optimally choose to become one of two types, “entrepreneurs” or “pensioners.” Entrepreneurs are active risk takers whose income is increasing in skill and subject to taxation. Pensioners live off taxes paid by entrepreneurs. Financial markets allow entrepreneurs to sell a fraction of their own firm and use the proceeds to buy a portfolio of shares in other firms and risk-free bonds. Since entrepreneurs cannot diversify fully, markets are incomplete.

Income Inequality And Asset Prices Under Redistributive Taxation

In equilibrium, agents become entrepreneurs if their skill is sufficiently high or risk aversion sufficiently low, or both. Intuitively, low-skill agents become pensioners because they would earn less as entrepreneurs, and highly risk-averse agents become pensioners because they dislike the idiosyncratic risk associated with entrepreneurship. These selection effects are amplified by higher tax rates because those make entrepreneurship less attractive. When the tax rate is high, only agents with the highest skill and/or lowest risk aversion find it optimal to become entrepreneurs. Therefore, under heavier taxation, entrepreneurs are more skilled and less risk-averse, on average, and total output is lower.

Inequality initially increases but eventually decreases with the tax rate. When the tax rate is zero, all agents choose to be entrepreneurs because pensioners earn no income. As the rate rises, inequality rises at first because agents who are extremely risk-averse or unskilled become pensioners. Such agents accept the low consumption of pensioners in exchange for shedding idiosyncratic risk, thereby increasing consumption inequality. As the tax rate rises further, inequality declines due to the direct effect of redistribution.

There are three sources of inequality: investment risk, stock market participation, and heterogeneity in skill. Investment risk causes differences in ex-post returns on entrepreneurs’ portfolios, in part due to idiosyncratic risk and in part because entrepreneurs with different risk aversions have different exposures to stocks. While entrepreneurs participate in the stock market, pensioners do not. Entrepreneurs consume more than pensioners on average, in part due to higher skill and in part as compensation for taking on more risk. Finally, not surprisingly, more heterogeneity in skill across entrepreneurs implies more inequality.

To explore the welfare implications of redistribution, we analyze inequality in expected utility, which we measure by certainty equivalent consumption. Inequality in expected utility is much smaller than consumption inequality, in part because pensioners tend to consume less than entrepreneurs but also face less risk. An increase in the tax rate reduces inequality in expected utility but it also reduces the average level of expected utility. In addition, the model yields a right-skewed distribution of consumption across agents.

Income Inequality And Asset Prices Under Redistributive Taxation

Income Inequality And Asset Prices Under Redistributive Taxation

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