Can Redistribution by Means of a Progressive Labor Income-Taxation Transfer System Increase Financial Stability?

We present a model featuring heterogeneous households with a conspicuous consumption motive, in which inequality can decrease financial stability, and relate this behavior to the recent financial crisis in the USA. A natural policy conclusion would be to combat income inequality jointly with financial instability by means of a progressive system of taxes and transfers. We investigate this for the case of a simple flat tax system on labor income. The system succeeds in decreasing volatility in asset markets by decreasing the share of high income individuals participating in destabilizing speculation. However, the model provides some very cautious notes on redistribution. As a result of redistribution, all agents are worse off class-wise and accumulate large amounts of debt, posing another potential hazard to financial stability. The latter can be explained by the arms race property of relative consumption. Moreover, the decreased inequality of income (flow) is accompanied by an increased inequality of net-worth (stock).