Exploring the Dynamics of Top Income Inequality

Top income inequality has risen sharply in the United States over the last 30 years but remained low and stable in economies like France and Japan. Why? This paper explores three theoretical mechanisms that endogenize the amount of top income inequality. The first model suggests that the rate of growth of top incomes is a key determinant. A rise in the returns to experience or an increase in effort devoted to accumulating human capital may increase top income inequality. The second model studies the direction of technological change and considers why it might be “talent biased,” at least along a transition path. Finally, the thirdmodel considers the allocation of talent. If thematching process between firms and talent is distorted, top income inequality can decline. The rise in top income inequality in theUnited States, then,may reflect an improvement in the allocation of talent. ∗We are grateful to seminar participants at the Federal Reserve Bank of San Francisco and Stanford for helpful comments.