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Politico-Economic Consequences of Rising Wage Inequality

  • Dean Corbae

    (The University of Texas at Austin)

This paper uses a dynamic political economy model to evaluate whether the observed rise in wage inequality can explain an increase in transfers and effective tax rates in the U.S. over the past two decades. Specifically, we assume that households have uninsurable idiosyncratic labor efficiency shocks along Aiyagari (1994) and consider policy choices by a median voter which are required to be consistent with a sequential equilibrium. We deal with the problem that policy outcomes affect the evolution of the wealth distribution by approximating the distribution by a small set of moments as in Krusell and Smith (1998). We calibrate the model to match properties of the U.S. earnings distribution in 1983 and then evaluate the response of the social insurance policies to the observed rise in wage inequality over the next decade and a half. This increase in wage dispersion is capable of explaining over two-thirds of the increase in effective taxes observed in the data while a utilitarian approach would explain only one-third of the change.

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Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 129.

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Date of creation: 2007
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Handle: RePEc:red:sed007:129
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  1. Aiyagari, S Rao, 1995. "Optimal Capital Income Taxation with Incomplete Markets, Borrowing Constraints, and Constant Discounting," Journal of Political Economy, University of Chicago Press, vol. 103(6), pages 1158-75, December.
  2. Jonathan Heathcote, 2005. "Fiscal Policy with Heterogeneous Agents and Incomplete Markets," Review of Economic Studies, Oxford University Press, vol. 72(1), pages 161-188.
  3. MaCurdy, Thomas E, 1981. "An Empirical Model of Labor Supply in a Life-Cycle Setting," Journal of Political Economy, University of Chicago Press, vol. 89(6), pages 1059-85, December.
  4. Rao Aiyagari, S. & Peled, Dan, 1995. "Social insurance and taxation under sequential majority voting and utilitarian regimes," Journal of Economic Dynamics and Control, Elsevier, vol. 19(8), pages 1511-1528, November.
  5. Krusell, P & Smith Jr, A-A, 1995. "Income and Wealth Heterogeneity in the Macroeconomic," RCER Working Papers 399, University of Rochester - Center for Economic Research (RCER).
  6. Krusell, Per & Quadrini, Vincenzo & Rios-Rull, Jose-Victor, 1997. "Politico-economic equilibrium and economic growth," Journal of Economic Dynamics and Control, Elsevier, vol. 21(1), pages 243-272, January.
  7. Marina Azzimonti-Renzo & Eva de Francisco & Per Krusell, 2006. "The political economy of labor subsidies," Working Paper 06-09, Federal Reserve Bank of Richmond.
  8. David Domeij & Jonathan Heathcote, 2004. "On The Distributional Effects Of Reducing Capital Taxes," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 45(2), pages 523-554, 05.
  9. Jonathan Heathcote & Kjetil Storesletten, 2005. "Insurance and Opportunities: The Welfare Implications of Rising Wage Dispersion," 2005 Meeting Papers 107, Society for Economic Dynamics.
  10. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  11. Jose-Victor Rios-Rull & Per Krusell, 1999. "On the Size of U.S. Government: Political Economy in the Neoclassical Growth Model," American Economic Review, American Economic Association, vol. 89(5), pages 1156-1181, December.
  12. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
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