A Schumpeterian Model of Top Income Inequality

Top income inequality rose sharply in the United States over the last 35 years but increased only slightly in economies like France and Japan. Why? This paper explores amodel inwhich heterogeneous entrepreneurs, broadly interpreted, exert effort to generate exponential growth in their incomes. On its own, this force leads to rising inequality. Creative destruction by outside innovators restrains this expansion and induces top incomes to obey a Pareto distribution. The development of the world wide web, a reduction in top tax rates, and a decline in misallocation are examples of changes that raise the growth rate of entrepreneurial incomes and therefore increase Pareto inequality. In contrast, policies that stimulate creative destruction reduce top inequality. Examples include research subsidies or a decline in the extent to which incumbent firms can block new innovation. Differences in these considerations across countries and over time, perhaps associated with globalization, may explain the varied patterns of top income inequality that we see in the data. ∗We are grateful to Philippe Aghion, Jess Benhabib, Xavier Gabaix, Mike Harrison, Pete Klenow, Ben Moll, Chris Tonetti, Alwyn Young, Gabriel Zucman and seminar participants at the AEA annual meetings, Chicago Booth, CREI, the Federal Reserve Bank of San Francisco, Groningen, HKUST, IIES Stockholm, Korea University, the NBER Income Distribution group, Princeton, Stanford, USC, and Zurich for helpful comments.