Income Inequality, Financial Intermediation, and Small Firms

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’ deposits 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 (p.p.) increase in the income share of the top 10% reduces the net job creation rate of small firms by 1.5–2 p.p., 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.