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ERC

MACROINEQUALITY Report Summary

Project ID: 324085
Funded under: FP7-IDEAS-ERC
Country: Norway

Final Report Summary - MACROINEQUALITY (The Macroeconomics of Inequality, Development and the Welfare State)

The research project The Macroeconomics of Inequality, Development and the Welfare State, financed by the European Research Council (Advanced Grant), has aimed at developing macro models with heterogeneity across people and firms to understand the consequences of two profound macro trends: the economic transformation of China and the rising inequality within countries.

The project has made significant progress on several fronts. The project has developed a novel model of partial insurance against individual wage risk, with the aim of quantifying how much risk people face, how well they are able to share this risk, and the extent to which optimal tax policies should be modified to provide public insurance. Surprisingly, and despite the richness of the model developed, it is possible to derive simple and intuitive closed-form analytical expressions for the allocations of consumption and hours worked as functions of the underlying wage risk.

As an application of this theoretical framework, the model is estimated on U.S. panel data with the aim of measuring the degree to which wage risk affects consumption and hours worked (Heathcote et al., AER 2014). A central insight is that labor supply data is informative about risk sharing. Moreover, the project demonstrates that wage data on its own does not suffice to account for the observed dispersion and dynamics of consumption and hours worked. Namely, preference heterogeneity represents an additional and quantitatively significant source of inequality.

A second application of this analytical partial insurance model analyzes the optimal degree of progressivity of the tax and transfer system (Heathcote et al., QJE 2017). On the one hand, a progressive tax system can substitute for the insurance against earning risk that markets fail to deliver and counteract the inequality individuals are born into. On the other hand, progressivity reduces incentives to work and to invest in skills. The project has developed a tractable equilibrium model that features all of these trade-offs. The model delivers a transparent understanding of how preference, technology, and the limits of insurance markets influence the optimal degree of progressivity.

A large part of the project focuses on China. The rapid economic transformation of emerging economies has raised many new questions for economic theory and policy. One project studies regional economic growth in China. While the average growth rate has been high, the economic progress has been highly uneven across locations. Using data from the Chinese Industry Census the project documents large dispersion across locations in terms of productivity, new firm start-up rates, and wages paid by private manufacturing firms in 1995, coupled with a rapid convergence after 1995. The project estimates a general equilibrium model allowing a range of economic frictions. The main culprit for explaining differences in performance across prefectures turns out to be differences in entry barriers, i.e., how difficult it is to start new firms. Exploring the empirical drivers of these entry barriers reveals that they are causally related to the size of the state sector. Thus, the downsizing of the state sector after 1997 may be a key explanation for the rapid regional convergence in local manufacturing performance over the 1995-2008 period.

The project has also studied intergenerational redistribution in China. A standard life-cycle model calibrated to China shows that the current pension system is underfunded – balancing the system would require major tax hikes and/or severe cuts in benefits. However, while delaying the implementation of such a reform implies large welfare gains for the (poorer) current generations, such a delay imposes only small costs on (richer) future generations. In contrast, a fully funded reform harms current generations, with small gains to future generations. This conclusion is driven by the assumption that the high current growth rates in wages and GDP will eventually stagnate as China approaches the technological frontier.

Finally, the project has shown that a government’s political leaning has a strong bearing on the accumulation of government debt: right-wing governments tend to accumulate more debt than left-wing governments because they tend to cut taxes in the short run, without cutting expenditures. This holds true for the U.S. in the post-war period and for a panel of OECD countries.

Reported by

UNIVERSITETET I OSLO
Norway
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