Income inequality, productivity, and international trade

This paper studies the effect of income inequality on selection and aggregate productivity in a general equilibrium model with non-homothetic preferences and product quality. The model matches the empirical fact that an increase in income shifts one’s consumption towards goods that have higher quality both at the intensive and extensive margins. It also implies a negative relationship between the number and quantity of goods consumed by an income group and the earnings of other income groups. The central result is that a mean-preserving spread of the income distribution negatively affects aggregate productivity through the softening of firms’ selection. In the presence of international trade, this effect is amplified with lower trade barriers or a larger number of trade partners. Furthermore, the model implies that the domestic expenditure shares and welfare gains from trade are constant across income groups. A simple quantitative exercise suggests that an income redistribution like the one induced by the US Federal taxes and transfers raises average productivity by about 3%.