Rising Profits and Low Interest Rates: What Policy Solutions Work?

Abstract

This paper links higher markups to the decline in US interest rates over the past three decades. Markups are generally seen as a tax on the other factors of production, reducing capital and labor demand. Business income accrued to households at the top of the income distribution, which also have a high marginal propensity to save. A simple model accounting for the effect of growing income inequality on saving behavior demonstrates a markup shock can have a relatively large impact on the equilibrium interest rate due to lower capital demand and a higher saving supply. In terms of policy options, the first-best response is to restore market competition between firms. Absent this possibility, the model explores second-best options: A redistributive tax between households cannot fully offset the shock and reduces the incentive for entrepreneurship. Still, it may generate welfare gains under certain conditions. An increase in government debt can raise the equilibrium interest rate, but will further crowd out capital and depress output, leading to welfare losses. A subsidy on capital and labor costs brings the economy the closest to its competitive allocation and may also generate welfare gains.