Since the 1970s the share of income accruing to high-income households in the US has increased substantially. Several studies investigate the causes of rising top incomes, or their consequences for households and aggregate demand (Auclert and Rognlie 2017, Mian et al. 2020). Much less is known, however, about the consequences of rising income inequality for firms and the production side of the economy. This limits our understanding of how inequality affects the economy and makes it difficult to fully assess policy proposals that target widening income disparities.
In a recent paper (Doerr et al. 2022), we characterise a novel mechanism through which rising top income shares alter the relative availability of funding between small and large firms, and thereby affect their job creation. The mechanism rests on two empirical observations. First, high-income households hold a lower share of their financial wealth in the form of deposits than low-income households, as shown in Figure 1. Instead, top earners invest in financial assets such as stocks or bonds. Second, banks’ access to deposits as a source of cheap funding affects their cost of funds and ability to grant loans, and small firms are more affected by changes in banks’ credit supply than large firms (see e.g. Gertler and Gilchrist 1994).
Figure 1 The allocation of financial assets across income groups
Source: Survey of Consumer Finances; Doerr et al. (2022).
Based on these observations, we argue that rising top income shares improve funding conditions for large firms, but increase financing costs for small firms through their negative effect on banks’ access to deposits. In turn, job creation among small firms declines, relative to large firms. We test this hypothesis empirically and build a quantitative general equilibrium model to study the consequences of rising top income shares for macroeconomic outcomes and welfare.
The effects of rising top income shares on job creation across states, firm sizes, and time
Our empirical analysis reveals a strong negative correlation between top income shares and small firm job creation in the US – both over time and across states (see Figure 2). To test our hypothesis formally, we exploit the variation in top incomes shares across US states in combination with a Bartik-style instrumental variable. We establish that a 10 percentage point increase in the top 10% income share significantly reduces the net job creation rate of small firms by around 2.5 percentage points, relative to large firms. The average increase in the state-level income share of the top 10% from 1980 to 2015 was around 10 percentage points, so the net job creation rate at small firms would have been around 2.5 percentage points higher today had top income shares remained at their 1980 levels. Relative to an average net job creation rate of small firms of around 4% during the 1980s, the effect is economically sizeable.
Figure 2 The rise in top incomes and the decline in small business
Source: Frank (2009), Business Dynamic Statistics, Doerr et al. (2022).
We provide evidence consistent with our proposed mechanism. For example, we establish that a given increase in top incomes reduces net job creation at small relative to large firms by more in industries that rely more on banks as a source of financing. We also investigate the effect of rising top incomes on bank deposits directly. We find that a rise in top income shares in the state of the bank’s headquarters has a significant negative effect on the amount of deposits and a positive effect on banks’ deposit expense. The relative fall in quantities and increase in prices is consistent with a relative reduction in households’ supply of deposits induced by rising top income shares. We obtain similar results for bank loans.
Our study also examines alternative explanations that could underlie the link between top incomes and job creation. For example, to rule out that the hypothesis that top income shares affect job creation through changes in local demand, we exclude non-tradable industries from our regressions and find similar effects. We also show that the effects we find are present both among new entrants and continuing small firms, but economically larger for continuing firms.
Inequality, aggregate employment, and the labour share
Motivated by our empirical findings, we build a macroeconomic model that incorporates the link between top income shares, household portfolio choice, and job creation. We calibrate the model to target the stylised facts and the causal estimates obtained from our empirical analysis. We then conduct quantitative experiments in the calibrated model. We start from an initial top 10% income share of 30%, resulting from permanent labour productivity heterogeneity between households. We then impose income transfers and taxes to raise the top 10% income share to 50%, matching its evolution in the US between the 1980s and today.
As more income accrues to the top earners, relatively more savings flow into direct investments (i.e. equity and bonds, reducing funding costs for large firms) rather than deposits (implying higher funding costs for small firms). As panel (a) of Figure 3 shows, this rise in top income shares and the associated change in the allocation of household savings reduces aggregate employment (black line). In particular, it reduces employment among private firms, but increases it among public firms. The negative effect on employment is strongest among the smallest firms, which are most reliant on bank funding, and must strongly cut employment as their funding costs rise.
Figure 3 Employment and the labour share
Source: Doerr et al. (2022).
On aggregate, our model results show that the increase in the top income share between 1980 and today accounts for about 16% of the overall decline in the small firm employment share over the time period (blue line in Figure 3, panel (b)). Specifically, the employment share of firms with less than 500 employees has fallen by around 5 percentage points since 1980, and rising top incomes, through their effect on funding conditions, explain almost 1 percentage point of the overall decline. This makes clear that our results connect two salient macro trends: the increase in top income shares and the shift in employment and dynamism from smaller, bank-funded to larger, publicly funded firms (Davis et al. 2006, Autor et al. 2020). Since small firms operate with a lower capital-to-labour ratio, the rise in top income shares and induced shift in economic activity towards larger firms also contributes to the decline in the labour share (red line), a key trend in the US and globally (Karabarbounis and Neiman 2014, Bughin et al. 2019, Kehrig and Vincent 2020).
Consequences for household welfare and the design of redistributive policies
We also study the consequences of rising top income shares for household welfare, in light of the mechanism we have uncovered. We find that an increase in the top 10% share has a larger negative impact on welfare of low-income households and a larger positive impact on welfare of high-income households, relative to a version of the model in which households do not adjust their portfolio.
This amplification arises from the impact of our channel on different sources of income. As the supply of deposits, and hence bank credit, declines, private firms become more constrained and their employment and wages fall. This disproportionately hurts low-income households by suppressing labour income. Without portfolio adjustment a higher share of income accruing to top earners would keep savings flowing to both public and private firms in the same proportion, and wages across the economy would rise. In contrast, richer households invest a higher share of their assets in the public firm as a result of receiving more income. As public firm investments yield higher returns than deposits, richer households see an increase in (capital) income and experience greater welfare gains, relative to a counterfactual scenario in which they keep their investments in deposits and the public firm fixed.
Summing up, our analysis yields several insights. First, rising income inequality benefits large firms but hurts small firms. Second, these effects matter in the aggregate, as they explain a sizeable share of the overall decline in small business as well as the labour share. And third, our experiments reveal that ignoring the key mechanism we uncover in our analysis leads to an understatement of the welfare effects of redistributive policies.
References
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Davis, S J, J Haltiwanger, R Jarmin, J Miranda, C Foote and E Nagypal (2006), “Volatility and dispersion in business growth rates: Publicly traded versus privately held”, NBER Macroeconomics Annual 21: 107–179.
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