Higher Taxes at the Top: The Role of Entrepreneurs

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1 Higher Taxes at the Top: The Role of Entrepreneurs Bettina Brüggemann * McMaster University October 9, 2017 PRELIMINARY AND INCOMPLETE Abstract This paper contributes to the recent and growing literature on optimal top marginal income tax rates. It computes optimal marginal tax rates for top earners in a Bewley-Aiyagari type economy explicitly accounting for entrepreneurs. Entrepreneurs make up more than one third of the highest-earning one percent in the income distribution despite representing less than ten percent of the population. They are thus disproportionately affected by an increase in the top marginal income tax rate. Since entrepreneurs overall also employ half of the private-sector workforce, such policy changes can have important repercussions for aggregate labor demand and productivity. In the model households face an occupational choice between working for the market wage or starting their own business. Borrowing constraints induce entrepreneurs to save in order to grow. Consistent with the data, entrepreneurs significantly influence aggregate productivity, generate 50 percent of total output, and account for 40 percent of taxpayers in the top tax bracket. Nonetheless, the welfare maximizing top marginal tax rate amounts to 75 percent, and the revenue maximizing one to 85 percent. A steady state comparison between the benchmark economy featuring the current US tax system and the economy with the welfare maximizing top marginal tax rate illustrates the underlying mechanisms. The substantial increase in taxes leads to a large degree of redistribution, yielding sizable welfare gains for low-income working and entrepreneurial households. The welfare gains decline with income for workers, as middle-income workers are hurt by lower equilibrium wages. These lower wages however benefit medium-sized entrepreneurs and enable them to grow, such that all entrepreneurs except those directly affected by the higher tax experience considerable welfare gains, and the size of the entrepreneurial sector grows. *I owe special thanks to my advisors, Nicola Fuchs-Schündeln and Alexander Bick, as well as Alexander Ludwig. Many thanks also go to Jonathan Heathcote at the Federal Reserve Bank of Minneapolis for hosting and advising me in the early stages of this project. Further, I would like to thank Zach Mahone, Jim Schmitz, Ctirad Slavík, Hitoshi Tsujiyama, and Jinhyuk Yoo, as well as numerous seminar and conference participants for their helpful comments and suggestions. All errors are mine.

2 Trade, skills and unemployment Maximiliano Dvorkin Federal Reserve Bank of St. Louis September, 2017 Preliminary and incomplete - please do not circulate Abstract In theory, trade is good. In practice, considerable debate exists on whether international trade has adverse effects, particularly on the labor market. Workers in different industries and occupations are not equally affected by international trade and some workers experience important earnings losses, job displacement and protracted periods of unemployment. I develop a frictional Ricardo-Roy model of the labor market to study the effects of trade liberalizations on workers with different characteristics and skills. The model extends the search-and-matching framework to the case of ex-ante heterogeneous workers that self-select into different labor markets according to their comparative advantage and embeds it into a Ricardian model of trade. I estimate the model for the U.S. economy and analyze the effects of a large surge in international trade. Consistent with a wealth of empirical evidence, I find important effects on manufacturing employment, unemployment and earnings losses caused by a mismatch between worker s skills and the skills demanded by firms after a trade liberalization. maximiliano.a.dvorkin@stls.frb.org. Asha Bharadwaj and Hannah Shell provided excellent research assistance. All views and opinions expressed here are my own and do not necessarily reflect those of the Federal Reserve Bank of St. Louis or the Federal Reserve System. 1

3 HETEROGENEITY AND PERSISTENCE IN RETURNS TO WEALTH Andreas Fagereng Research Dept. Statistics Norway Luigi Guiso Einaudi Institute for Economics and Finance Rome, Italy Davide Malacrino Stanford University Economics Dept. Luigi Pistaferri Stanford University Economics Dept. Working Paper NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA November 2016 ABSTRACT We provide a systematic analysis of the properties of individual returns to wealth using twenty years of population data from Norway s administrative tax records. We document a number of novel results. First, in a given cross-section, individuals earn markedly different returns on their assets, with a difference of 500 basis points between the 10th and the 90th percentile. Second, heterogeneity in returns does not arise merely from differences in the allocation of wealth between safe and risky assets: returns are heterogeneous even within asset classes. Third, returns are positively correlated with wealth. Fourth, returns have an individual permanent component that accounts for 60% of the explained variation. Fifth, for wealth below the 95th percentile, the individual permanent component accounts for the bulk of the correlation between returns and wealth; the correlation at the top reflects both compensation for risk and the correlation of wealth with the individual permanent component. Finally, the permanent component of the return to wealth is also (mildly) correlated across generations. We discuss the implications of these findings for several strands of the wealth inequality debate. We thank Alberto Bisin, Fatih Guvenen, Gueorgui Kambourov, Daniele Massacci, Giovanni Mastrobuoni, Benjamin Moll, Andrea Pozzi, Ali Shourideh, and Anton Tsoy for very fruitful discussions. We are grateful for useful comments from seminar participants at the 2016 ASSA meetings, the NBER Summer Institute, Bocconi University, EIEF, European University Institute, University of Chicago, UC Berkeley, Fudan University, HEC Montreal, UC Santa Cruz, MIT Sloan, Northwestern, Kellogg, NY FED, Santa Clara University, Statistics Norway, the 2016 QSPS meeting at Utah State, and the 2016 Cowles Macro/Labor conference at Yale. Funding from the Research Council of Norway is gratefully acknowledged. Funding from the Research Council of Norway is gratefully acknowledged. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications by Andreas Fagereng, Luigi Guiso, Davide Malacrino, and Luigi Pistaferri. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is given to the source.

4 Assortative Matching and Household Income Inequality: A Structural Approach Laura Pilossoph (Federal Reserve Bank of New York) Shu Lin Wee (Carnegie Mellon University) Abstract: Income inequality across households has risen dramatically in the last 40 years. At the same time, there have been significant changes in the determinants of household income, including educational attainment, the skill premium, and marital sorting patterns. We link these phenomenon through an equilibrium model of investment in schooling, marriage, and household search. The present discounted value of search in the labor market at the household level determines the surplus generated by each marriage for each education pair, determining equilibrium educational attainment and the degree of marital sorting. In this environment, we show that the direction of marital sorting depends on the degree of search complementarities in the labor market. Using an estimated version of the model, we construct counterfactual income distributions under changing primitives (i.e., marital preferences and skill premia) that let the degree of sorting, educational attainment, and inequality respond to movements in those primitives.

5 Redistribution and Fiscal Uncertainty Shocks Hikaru Saijo University of California, Santa Cruz Abstract: This paper revisits the macroeconomic impact of an uncertainty shock about fiscal policy in a New Keynesian framework. Motivated by the observation that many fiscal policies are redistributive and that many U.S. households do not own capital, I introduce household heterogeneity in the form of limited capital market participation. I show that household heterogeneity significantly magnifies the aggregate effect and restores co-movement of macroeconomic variables in a contraction that is generated by a fiscal uncertainty shock. This is because the heterogeneous household model captures individual uncertainty about redistribution that cancels out in representative agent models. A counterfactual experiment shows that once household heterogeneity is taken into account, an increase in fiscal uncertainty becomes an important factor that explains Great Recession and its slow recovery.

6 The Role of Learning for Asset Prices and Business Cycles Fabian Winkler 1 March 2017 Abstract I examine the implications of learning-based asset pricing in a model in which firms face credit constraints that depend partly on their market value. Agents learn about stock prices, but have conditionally model-consistent expectations otherwise. The model jointly matches key asset price and business cycle statistics, while the combination of financial frictions and learning produces powerful feedback between asset prices and real activity, adding substantial amplification. The model reproduces many patterns of forecast error predictability in survey data that are inconsistent with rational expectations. A reaction of the monetary policy rule to asset price growth increases welfare under learning. JEL: D83, E32, E44, G12 Keywords: Learning, Expectations, Financial Frictions, Asset Pricing, Survey Forecasts 1 Introduction Financial frictions are a central mechanism by which asset prices interact with macroeconomic dynamics. But to understand this interaction, we need models that are able to capture the dynamics of asset prices in the data. Moreover, the interaction is likely two-sided, with feedback from asset prices to the real economy, but also from the real economy to asset prices. Asset price dynamics observed in the data should therefore arise endogenously in our models. At the same time, there is evidence that measures of expectations do not conform to the rational expectations hypothesis, even in financial markets. The rational expectations hypothesis implies, Board of Governors of the Federal Reserve System, 20th St and Constitution Ave NW, Washington DC 20551, fabian.winkler@frb.gov. I thank my former advisors Wouter den Haan and Albert Marcet, my discussant at the NBER Summer Institute Martin Schneider, as well as Klaus Adam, Andrea Ajello, Johannes Boehm, Rachel Ngai, Markus Riegler, and participants at the NBER Summer Institute 2016, Bank of Spain, Econometric Society World Congress in Montreal, Econometric Society Winter Meeting in Madrid, EEA Annual Meeting in Toulouse, ECB- CFS-Bundesbank lunchtime seminar, and Singapore Management University, for comments and suggestions. The views herein are those of the author and do not represent the views of the Board of Governors of the Federal Reserve System or the Federal Reserve System. 1