Taxing the Rich? A Theory of Income and Wealth Inequality 

Abstract:

Recently, it has been argued that a progressive wealth tax may significantly benefit the distribution of welfare in society with minimal adverse effects on real economic activity. This paper evaluates the merits of this view within a dynamic general equilibrium framework that microfounds empirically plausible income and wealth distributions as arising from a fundamental agency problem between managers and entrepreneurs, on the one hand, and capital markets, on the other hand. In this framework, wealth taxes distort the effort that managers and entrepreneurs expend to create firm value, which capital markets reward them for, by shifting their choice of projects towards less productive ventures. When wealth taxes are broad-based enough to affect not just individuals at the top of the wealth distribution, who contribute the most to firms' productivity, they help reduce inequality but depress capital accumulation and output in the economy. The model accounts well for the degree of income and wealth inequality observed in the United States, including the very different degrees of concentration of the distributions of income and wealth at the top. The model also implies a substantial output loss from wealth taxes of the magnitude currently being debated. The reduction in inequality that wealth taxes lead to would be achieved at a much lower cost by modestly increasing the progressivity of income taxes rather than by introducing progressive wealth taxes.