From Income to Wealth Inequality Trickle-Down vs. Capital Gains

How price changes affect wealth

Non-Technical Summary

The question. Since the 1970s, the gap between high and low earners in the United States has grown sharply. This is true of yearly pay, and also of what people can expect to earn over their whole careers. People with high lifetime earnings save a larger share of their income. So when earnings become more unequal, aggregate savings rises. That extra saving has to go somewhere, and where it goes changes wages, interest rates and asset prices. We ask how these price changes in turn affect who owns the wealth.

Two possible outcomes. One possibility is that the extra saving pays for new factories, machines and offices. Capital becomes more plentiful, so interest rates fall and wages rise. Workers gain, savers earn less on their wealth, and wealth gaps narrow. We call this the trickle-down channel. The name describes the direction of the effect, not a policy.

The other possibility is that the extra saving bids up the price of assets that already exist, such as company shares. Wages then barely move, and the resulting capital gains accrue mainly to those who already own such assets, who are mostly the wealthiest households. We call this the capital-gains channel, and it widens wealth gaps.

What decides between them: market power. Firms with market power charge prices above their costs and earn profits beyond what their buildings and machines alone would earn. Their shares are therefore worth more than their physical capital. When interest rates fall, those future profits become more valuable straight away. Part of the extra saving then raises share prices instead of building new capital.

Timing matters too. In the very long run, trickle-down wins: lower interest rates and higher wages slowly narrow wealth gaps. But share prices jump as soon as investors expect lower rates. That one-off gain goes to existing owners and gives the top a head start that lasts for decades. Comparing the economy only before and after the change, as most studies do, misses this gain entirely.
 
What we find. We build a model of the U.S. economy in 1970 with households that differ in earnings and wealth. We then feed it the rise in earnings inequality observed from 1970 to 2019, revealed year by year as it happened. Firms have market power, at the low end of estimates for that period. Under these assumptions:
-    By 2020, the price changes alone raise the average wealth of the top 0.1% by 25%, the top 1% by 18%, and all households by 8%.

-    With no market power, the same price changes would have lowered wealth for everyone: by 4–5% for households above the median and by 9% for the bottom half.

-    The price changes explain about a quarter of the observed rise in the top 1%'s share of wealth.

-    Overall, rising earnings inequality accounts for two fifths of the rise in household wealth relative to national income. It also accounts for a quarter of the rise in stock-market values relative to the capital firms own.

Why it matters. Our results suggest that rising income inequality and rising wealth inequality feed each other through asset prices: when the rich save more, what they already own becomes worth more. Whether extra saving at the top trickles down to workers depends on how much market power firms have. In our model of the U.S. since 1970, the capital-gains channel has won for five decades.

Keywords: Wealth Inequality, Permanent Income, Markups, Capital Gains, Tobin's Q

Codes JEL : D31, E21, E25, E44