Evolution of Inequality In the U.S.: Entrepreneurial Activity and Financial Intermediation

There are two major trends in US entrepreneurship since 1975: (1) entrepreneurs' leverage has risen; and (2) their number has fallen. This paper investigates the extent to which these trends have contributed to the observed rise in wealth inequality. I develop a general equilibrium, overlapping-generations model with occupational choice where individuals choose to be workers or entrepreneurs. Entrepreneurs borrow for investment and may default on debt. The cost of borrowing, for entrepreneurs, is consistent with their individual risk of default. This explicit modeling of entrepreneurs' default risk is one of the features that distinguishes this paper from the existing literature on wealth inequality. In the model economy, two main mechanisms generate inequality: forward- looking credit constraints that are driven by default risk and stochastic returns to saving. To study changes in wealth inequality over time, I investigate changes in four channels: a greater ability on the part of lenders to make risky loans, an increase in costs of starting a business, a fall in unit cost of borrowing, and a change in exemptions in the bankruptcy code. These changes are consistent with the evolution of the US economy. I examine which channels can reproduce trends in entrepreneurship seen in the data. The first two channels prove to be important. A rise in the ability of lenders to make risky loans and an increase in costs of starting a business lead to a fall in the rate of entrepreneurship and a rise in their average leverage as observed in the data. When these trends are accounted for, the model explains almost all of the rise in the wealth share of the top one percent between 1975 and 2007.