Wealth inequality, preference heterogeneity and macroeconomic volatility in two-sector economies

We explore the link between wealth inequality, preference heterogeneity and macroeconomic volatility in a two-sector neoclassical growth model. First we prove that, if agents have homogeneous preferences, when the absolute risk tolerance is a strictly convex (concave) function, sufficiently high (low) levels of wealth inequality may lead to endogenous fluctuations in the neighborhood of the steady state. Second, we consider the effects of preference heterogeneity when agents are homogeneous with respect to their wealth. We show that when the utility function belongs to the HARA class, sufficiently high levels of preference heterogeneity may lead to endogenous fluctuations in the neighborhood of the steady state if the elasticity of intertemporal substitution in consumption is greater than one.     

Wealth inequality and dynamic stability

We explore the link between wealth inequality and stability in a two-sector neoclassical growth model with heterogeneous agents. We show that when the inverse of absolute risk aversion (or risk tolerance) is a strictly convex function, wealth inequality is a factor that favors instability. In the opposite case, inequality favors stability. Our characterization also shows that whenever absolute risk tolerance is linear, as when preferences exhibit hyperbolic absolute risk aversion (HARA), wealth heterogeneity is neutral.     

Endogenous groups and dynamic selection in mechanism design

We create a dynamic theory of endogenous risk sharing groups, with good internal information, and their coexistence with relative performance, individualistic regimes, which are informationally more opaque. Inequality and organizational form are determined simultaneously. Numerical techniques and succinct reformulations of mechanism design problems with suitable choice of promised utilities allow the computation of a stochastic steady state and its transitions. Regions of low inequality and moderate to high wealth (utility promises) produce the relative performance regime, while regions of high inequality and low wealth produce the risk sharing group regime. If there is a cost to prevent coalitions, risk sharing groups emerge at high wealth levels also. Transitions from the relative performance regime to the group regime tend to occur when rewards to observed outputs exacerbate inequality, while transitions from the group regime to the relative performance regime tend to come with a decrease in utility promises. Some regions of inequality and wealth deliver long term persistence of organization form and inequality, while other regions deliver high levels of volatility.     

Labor or consumption taxes? An application with a dynamic general equilibrium model with heterogeneous agents

This study analyzes the effects of tax reform that shifts tax burden from labor to consumption. In this context, I also deal with the issue of progressivity. Even though this kind of tax policy change has recently gained popularity, its positive effects are debatable while the offsetting effect of a consumption tax on labor supply makes the net output change rather ambiguous. I examine these effects using a dynamic general equilibrium model with heterogeneous agents. The model is calibrated to fit certain characteristics of the Finnish economy. In addition to output and employment effects, I study the tax reform's effect on income and wealth distribution. First, I find that eliminating progressivity in labor taxation increases output via increase in capital accumulation that comes, however, in expense of slightly more inequality. Then, tax reform that replaces progressive labor taxes with a flat-rate consumption tax leads to a significant rise in capital accumulation, a negligible change in labor supply and gross labor income distribution, but a relatively considerable increase in wealth concentration.     

Wealth Effects, Distribution, and the Theory of Organization

We construct a general equilibrium model of firm formation in which organization is endogenous. Firms are coalitions of agents providing effort and investment capital. Effort is unobservable unless a fixed monitoring cost is paid, and borrowing is subject to a costly state verification problem. Because incentives vary with an agent's wealth, different types of agents become attractive firm members under different circumstances. When borrowing is not costly, firms essentially consist of one type of agent and are organized efficiently. But when the costly state verification problem is sufficiently severe, firm organization will depend on the distribution of wealth: with enough inequality, it will tend to be dictated by incentives of rich agents to earn high returns to wealth, even if the chosen organizational form is not a technically efficient way to provide incentives.Journal of Economic LiteratureClassification Numbers: D2, D31, J41, L2.     

Envy and Inequality*

We present an overlapping generations economy, populated by heterogeneous agents who care about both consumption relative to others and the bequest they leave to their offspring. We show that saving and bequest rates vary across the income distribution, and we obtain several interesting results. First, envy reduces the steady‐state capital stock and increases the degree of inequality in consumption, capital ownership, and bequests. Second, if the bequest motive is sufficiently strong the equalizing effect of bequests disappears. Third, income inequality for a given cohort increases with age. Fourth, the distribution of inherited wealth becomes more unequal than that of wealth in general. Fifth, economic position becomes more persistent across generations.     

The dynamics of inequality and social security in general equilibrium

This paper analyzes the dynamic politico-economic equilibrium of a model where repeated voting on social security and the evolution of household characteristics in general equilibrium are mutually affected over time. In particular, we incorporate within-cohort heterogeneity in a two-period Overlapping-Generation model to capture the intra-generational redistributive effect of social security transfers. Political decision-making is represented by a probabilistic voting à la Lindbeck and Weibull (1987). We analytically characterize the Markov perfect equilibrium, in which social security tax rates are shown to be increasing in wealth inequality. A dynamic interaction between inequality and social security leads to larger social security programs. In a model calibrated to the U.S. economy, the dynamic interaction is shown to be quantitatively important: It accounts for more than half of the social security growth in the dynamics. We also perform some normative analysis, showing that the politico-economic equilibrium outcomes can be fundamentally different from the Ramsey allocation.     

Income and wealth distribution in a simple model of growth

Summary. This paper studies a deterministic one-sector growth model with a constant returns to scale production function and endogenous labor supply. It is shown that the distribution of capital among the agents has an effect on the level of per-capita output. There exists a continuum of stationary equilibria with different levels of per-capita output. If the elasticity of intertemporal substitution is large, a higher output level can be achieved when income inequality is great, that is, when the income distribution is strongly dispersed. If the elasticity of intertemporal substitution is low, the reverse relation holds. The paper shows that countries with identical production technologies and identical preferences may have different GDP levels because wealth is distributed differently among their inhabitants. Received: January 29, 1999; revised version: October 4, 1999     

Perceptions of inequality

Individual perceptions of (income or wealth) inequality have strong effects on their decisions as economic agents or voters. It is therefore important to know more about the relation between perceived and measured inequality. We present a novel formal framework that is based on the assumption that people typically do not observe the entire income (wealth) distribution and that their guesses about the extent of inequality are based on “self-centered” reference groups. This framework predicts that perceptions of inequality will change along positions in the income distribution and that for a specific position various dimensions of inequality perception are related to each other. First, low (high) income individuals overestimate (underestimate) their own position. Second, subjective estimates of average earnings increase with the own income position. Third, high or low income people have different perceptions about the skewness and the “shape” of the income distribution (e.g. pyramid or diamond). Fourth, the subjective perception of inequality is lower for high-income individuals. Survey data from 40 countries provide strong support for the framework.     

Are rich people smarter?

We formulate a general stochastic process of wealth accumulation by capital investment and analyze the conditions required to ensure convergence to the empirically observed Pareto wealth distribution. While homogeneous investment talent leads to the Pareto distribution under very general conditions, even a mild degree of differential investment talent results in a non-Pareto wealth distribution. This finding suggests that chance, rather than differential investment talent, is the dominant factor in the process of wealth accumulation by financial investment. Our findings conform with market efficiency and may have implications regarding the origins, the economic significance, and the social desirability of wealth inequality at the high-wealth range.     

Optimal cycles and social inequality: What do we learn from the Gini index?

One of the plausible explanations for macroeconomic fluctuations relies on the occurrence of endogenous deterministic cycles. In the last three decades, most of the relevant literature has rested on the assumption of a representative agent but, recently, a few papers have investigated the role of consumers' heterogeneity on endogenous fluctuations. Our article aims at taking a step forward in order to give a more suitable interpretation. To keep things as simple as possible, we introduce heterogeneous households in a two-sector optimal growth model and we study how wealth heterogeneity affects the occurrence of endogenous cycles. In contrast to previous results, we relate the existence of such cycles to the most commonly used inequality measure, the Gini index, and analyze the impact of consumers' heterogeneity on this index.     

Voting blocs, party discipline and party formation

I study the strategic incentives to coordinate votes in an assembly. Coalitions form voting blocs, acting as single players and affecting the policy outcome. In an assembly with two exogenous parties I show how the incentives to accept party discipline depend on the types of the agents, the sizes of the parties, and the rules the blocs use to aggregate preferences. In a game of fully endogenous party formation, I find sufficient conditions for the existence of equilibria with one bloc, two blocs, and multiple blocs.     

Older or Wealthier? The Impact of Age Adjustment on Wealth Inequality*

Differences in individual wealth holdings are widely viewed as a driving force of economic inequality. However, as this finding relies on cross‐sectional data, a concern is that older is confused with wealthier. We propose a new method to adjust for age effects in cross‐sections, which eliminates wealth inequality due to age, yet preserves inequality arising from other factors. Using a new cross‐country comparable database, we examine the impact of age adjustments on wealth inequality across countries and over time. We find that the most widely used method yields a substantially different picture of age‐adjusted wealth inequality than our method.     

Inequality and network structure

We explore the manner in which the structure of a social network constrains the level of inequality that can be sustained among its members, based on the following considerations: (i) any distribution of value must be stable with respect to coalitional deviations, and (ii) the network structure itself determines the coalitions that may form. We show that if players can jointly deviate only if they form a clique in the network, then the degree of inequality that can be sustained depends on the cardinality of the maximum independent set. For bipartite networks, the size of the maximum independent set fully characterizes the degree of inequality that can be sustained. This result extends partially to general networks and to the case in which a group of players can deviate jointly if they are all sufficiently close to each other in the network.     

Unequal opportunities and human capital formation

This paper develops a tractable, heterogeneous agents general equilibrium model where individuals have different endowments of the factors that complement the schooling process. The paper explores the relationship between inequality of opportunities, inequality of outcomes, and aggregate efficiency in human capital formation. Using numerical solutions we study how the endogenous variables of the model respond to two different interventions in the distribution of opportunities: a mean-preserving spread and a change in the support. The results suggest that a higher degree of inequality of opportunities is associated with lower average level of human capital, a lower fraction of individuals investing in human capital, higher inequality in the distribution of human capital, and higher wage inequality. In particular, the model does not predict a trade-off between aggregate efficiency in human capital formation (as measured by the average level of human capital in the economy) and equality of opportunity.     

Redistributive taxation,wealth distribution,and economic growth

This paper examines the relationship between wealth distribution and economic growth in an endogenous growth model with heterogeneous households and redistributive taxation. In this paper, we incorporate an endogenous determination of redistributive policy into the model, focusing on the relation between pre- and post-tax inequality. Endogenous redistributive policy affects wealth distribution and economic growth. Therefore, the relation between post-tax inequality and economic growth is different from that between pre-tax inequality and economic growth. Results show that there exists a negative correlation between pre-tax inequality and economic growth, whereas there exists an inverted-U relationship between post-tax inequality and economic growth in a voting equilibrium.     

Income distributions and decomposable divergence measures

Inequality indices evaluate the divergence between the income distribution and the hypothetical situation where all individuals receive the mean income, and are unambiguously reduced by a Pigou–Dalton progressive transfer. This paper proposes a new approach to evaluate the divergence between any two income distributions, where the latter can be a reference distribution for the former. In the case where the reference distribution is perfectly egalitarian – and uniquely in this case – we assume that any progressive transfer reduces the divergence, and that the divergence can be additively separated into inequality and efficiency loss. We characterize the unique class of decomposable divergence measures consistent with these views. We derive the associated relative and absolute subclasses, and we illustrate the applicability of our results. This approach extends the generalized entropy studied in inequality measurement.     

Wealth Inequality and Asset Pricing

In an Arrow–Debreu exchange economy with identical agents except for their initial endowment, we examine how wealth inequality affects the equilibrium level of the equity premium and the risk-free rate. We first show that wealth inequality raises the equity premium if and only if the inverse of absolute risk aversion is concave in wealth. We then show that the equilibrium risk-free rate is reduced by wealth inequality if the inverse of the coefficient of absolute prudence is concave. We also prove that the combination of a small uninsurable background risk with wealth inequality biases asset pricing towards a larger equity premium and a smaller risk-free rate.     

Comment on “Correlated information, mechanism design and informational rents” [J. Econ. Theory 123 (2) (2005) 210–217]

We amend an error in [S. Parreiras, Correlated information, mechanism design and informational rents, J. Econ. Theory 123 (2005) 210–217]. Consequently, it is in general not possible to reinterpret a mechanism design model that violates the spanning condition of Crémer and McLean [J. Crémer, R. McLean, Full extraction of the surplus in bayesian, dominant strategy auctions, Econometrica 56 (1988) 1247–1258] as one in which agents hold private information about the informativeness of their signals about other agents? types. Instead, such an interpretation is warranted only when the weights used to span an agent?s set of beliefs stand in a singular relation with the prior type distribution that is known as an alternative characterization of Blackwell dominance.     

Wealth inequality,governance and economic growth

Links between economic growth and inequality are of growing interest for researchers and policy makers. Previous studies of this relationship have focused mainly on inequalities in income rather than in wealth. Yet from many perspectives wealth inequality is arguably more important. Using a new panel data set from Credit Suisse for 45 sample countries over the period 2000–2012, this study investigates the effects of wealth inequality on economic growth. Empirical results from system GMM estimation suggest that the wealth inequality is negatively associated with cross-country economic growth. This result is robust to alternative estimators and measures of wealth inequality, as well as the econometric specification. Further empirical investigation reveals that impact of wealth inequality on growth is mitigated by better governance.