Pareto Distributions and the Evolution of Top Incomes in the U.S.

This paper presents a dynamic general equilibrium model with heterogeneous firms and entrepreneur's portfolio choice. We analytically show that this model generates the Pareto distribution of top income earners and Zipf's law of firms at the steady state. The differential equation for the probability density distribution of income is derived and numerically evaluated. In the model, CEOs respond to a tax cut by increasing their share of stocks of their own firms, thereby increasing the diffusion of their wealth. The calibrated model shows that the transition path matches with the decline of the Pareto exponent of the income distribution and the trend of top 1% income share in the U.S. in recent decades. We argue that the low marginal income tax at the top bracket of income could lead to the higher dispersion of income among the top income earners, which results in the higher concentration of income in the top income group.