Zipf's Law, Pareto's Law, and the Evolution of Top Incomes in the U.S.

Abstract

We construct a tractable neoclassical growth model that generates Pareto's law of income distribution and Zipf's law of the firm size distribution from idiosyncratic, firm-level productivity shocks. Executives and entrepreneurs invest in risk-free assets as well as their own firms' risky stocks, through which their wealth and income depend on firm-level shocks. By using the model, we evaluate how changes in tax rates can account for the evolution of top incomes in the U.S. The model matches the decline in the Pareto exponent of the income distribution and the trend of the top 1% income share in recent decades.