Income inequality, financial intermediation, and small firms

Summary

Focus

This paper studies how income inequality affects job creation and finds that it reduces the number of jobs created by smaller firms.

Contribution

While existing research looks at the effects of inequality on households, this paper is among the first to show that income inequality also affects businesses. This evidence is based on four decades of data on top income shares across US states, combined with detailed information on job creation by firms of different sizes.

Findings

Rising income inequality reduces job creation by small relative to large firms. High-income households save relatively less in the form of bank deposits than do low-income households. Thus, rising top income shares reduce banks' access to deposits and hence their ability to lend. As small firms depend more on bank financing than large firms, the contraction in lending hinders job creation at small firms. The paper provides evidence for these effects, complementing the analysis with a macroeconomic model for simulation experiments.

Abstract

This paper shows that rising income inequality reduces job creation at small firms. High-income households save relatively less in the form of bank deposits while small firms depend on banks. We argue that a higher share of income accruing to top earners therefore erodes banks' deposit base and their lending capacity for small businesses, thus reducing job creation. Exploiting variation in top incomes across US states and an instrumental variable strategy, we establish that a 10 percentage point (pp) increase in income share of the top 10% reduces the net job creation rate of small firms by 1.5–2 pp, relative to large firms. The effects are stronger at smaller firms and in bank-dependent industries. Rising top incomes also reduce bank deposits and increase deposit rates, in line with a reduction in the supply of household deposits. We then build a general equilibrium model with heterogeneous households that face a portfolio choice between high-return investments and low-return deposits that insure against liquidity risk. Banks use deposits to lend to firms of different sizes subject to information frictions. We study job creation across firm sizes under counterfactual income distributions.

JEL-classification: D22, D31, G21, L25
Keywords: income inequality, job creation, small businesses, bank lending, household heterogeneity, financial frictions