Taxing the Rich? A Theory of Income and Wealth Inequality

Recently, it has been argued that a progressive wealth tax may have a large beneficial impact on the distribution of welfare in society and effectively no 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 tilting their choice of projects towards less productive ventures. If wealth taxes are broad-based enough to affect individuals at the top of the wealth distribution, who contribute the most to firms’ productivity, then they end up depressing capital accumulation and output in the economy. Our preliminary simulations show that even a simple version of the model accounts well for the degree of income and wealth inequality in the United States, including the distinct degrees of concentration of the distributions of income and wealth. The model implies a substantial aggregate output loss from wealth taxes of the magnitude currently being debated, which leads to a reduction in inequality that would be achieved at a much lower cost by modestly increasing the progressivity of income taxes rather than by introducing wealth taxes.