Financial Innovations, Taxes, and the Growth of Finance

Abstract

The U.S. economy since 1980 has experienced the growth of finance, manifested by the increases in the value-added of financial services and the value of financial assets. The growth of finance has been associated with the increase in the mutual fund share in the financial assets and the relatively stable unit cost of finance. This paper constructs an incomplete market dynamic general equilibrium model with the islands structure, which has both idiosyncratic and island-level shocks on the firm’s productivity. Financial intermediaries trade shares of individual firms and risk-free debts, as well as mutual funds which diversify away idiosyncratic shocks but can not diversify island-level shocks. This model, together with the declining transaction costs on mutual funds and personal and corporate income tax rates calibrated from data, can quantitatively account for these facts.