Politico-Economic Consequences of Rising Wage Inequality

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.