Redistribution of Return Inequality: Student Work in Progress Seminar

Wealthier households obtain higher returns on their investments than poorer ones. How should the tax system account for this return inequality? I study capital taxation in an economy in which return rates endogenously correlate with wealth. The leading example is a financial market, where the rich acquire more financial information than the poor. Contrary to conventional wisdom, rather than calling for more redistribution, the presence of this scale dependence provides a rationale for lower marginal tax rates. The endogeneity of returns generates a feedback effect between wealth and its returns. Therefore, standard elasticity measures that determine the responsiveness of capital to taxes must be revised upwards. At an aggregate level, a rise in redistribution induces a compression effect on the distribution of returns. In the financial market, I identify general equilibrium trickle-up externalities that provide a force for more redistribution relative to the partial equilibrium. Using a panel of US foundations, I estimate the quantitative importance of scale dependence for tax policy.

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