Financial frictions, occupational choice and economic inequality

Abstract

We develop a quantitative theory of entrepreneurship, income inequality, and financial frictions disciplined with household data from Brazil. The theory extends Lucas (1978) by modeling heterogeneity in two skills: -working and managerial skills. Consistently with the evidence, the theory implies three occupational categories: workers, employers, and self-employed entrepreneurs. We find that the removal of financial frictions decreases self-employment rates from 24% to 11% (with small effects on the number of employers), increases aggregate output by 48%, and has non- trivial effects on the distribution of income. We also find that while most households benefit from a reform that eliminates enforcement problems, the majority of employers (about two thirds) lose from the reform. By depressing the demand for labor, limited enforcement depresses the equilibrium wage rate, increasing the profits of employers. Our theory thus suggests that employers in Brazil may have a vested interested in maintaining a status quo with low enforcement.