Redistribution, inequality, and efficiency with credit constraints

We develop a model that characterizes the joint determination of income distribution and macroeconomic aggregate dynamics. We identify multiple channels through which alternative public policies such as transfers, consumption and income taxes, and public investment will affect the inequality–efficiency trade off. Some policy changes can affect net income inequality both directly, and indirectly by inducing structural changes in the private-public capital ratio. This in turn influences market inequality and determines the distribution of the next period’s investment and net income. Income tax and transfers have both a direct income effect and an indirect substitution effect, whereas the consumption tax has only the latter. After developing some theoretical propositions summarizing these policy tradeoffs, we present extensive numerical simulations motivated by the South African National Development Plan 2030, the objective of which is to tame soaring inequality and increase per capita GDP. Our numerical simulations illustrate how the judicious combination of these policies may help achieve these targets. The simulations also suggest that the sharp decline in private-public capital ratio coupled with high degree of complementarity between the public and private capitals could be behind the persistence of market inequality in South Africa during the last two decades.