Earnings Inequality and the Equity Premium

We present data from the Survey of Consumer Finances showing that the increased earnings (labor income) inequality, in combination with increased stockmarket participation, has roughly doubled stockholders share of aggre-gate labor income in the last four decades. We explore the impact of the increase in this share on returns to equity and returns to a risk-free bond in a model with limited stockmarket participation, labor income and borrowing constraints. The main result is that the increase in stockholdersshare of ag-gregate labor income has lead to 130 basis points (45 percent) decrease in the ex ante equity premium (i.e. the discount rate applied to equity). The reason for this change is that the increase in stockholders share of aggregate labor income leads to a change in income composition for stockholders- a decrease in the fraction of their income that consists of dividend income. This reduces the covariance between stockholders total income growth and dividend growth. The size of the decrease in the equity premium implied by our model roughly coincides with the historical change in the post-1951 equity premium implied by the simple dividend growth model in Fama and French (2002).