# **1 Introduction**

The determinants of income inequality are a contentious topic of debate among economists, politicians, and policy makers alike. Many factors, such as family background, demographics, discrimination, genetics, luck, and work ethic play a role in determining economic success. All of these factors ultimately contribute to two higher level determinants of labor income inequality: (1) differences in productivities, i.e., ability to transform labor into personal income, and (2) differences in preferences, i.e., desire for consumption relative to leisure.<sup>1</sup> Note our definition of preferences is narrow in that it refers only to the taste for consumption relative to leisure whereas our definition of productivity is broad in that it encompasses not only things like intelligence or social skills but also things like human capital acquisition, discrimination, or rent seeking, which all ultimately impact ones ability to transform labor into income.

Understanding the determinants of income inequality is important because social welfare gains associated with redistribution depend on _why_ we have inequality. A number of studies have shown that individuals’ redistributive tastes may be influenced by how much of income inequality is driven by preferences. In experimental settings, individuals appear less inclined toward redistribution when income differences are due to differences in preferences, which manifests as differential effort (e.g., Hoffman et al. (1994), Cherry et al. (2002), or Rey-Biel et al. (2011)). Moreover, Alesina et al. (2001) find that countries in which individuals believe income is driven primarily by preference differences tend to have less redistributive policies. Hence, individuals’ _normative_ tastes for redistribution appear to depend on the sources of income inequality; thus, examining the extent to which income inequality is driven by productivity vs. preference heterogeneity is a _positive_ step towards understanding the welfare benefits of redistribution.<sup>2</sup> This paper shows that we can use information encoded in labor supply elasticities to learn about the extent to which labor income inequality is driven by heterogeneity in productivities vs. heterogeneity in preferences for consumption relative to leisure. To see why labor supply elasticities contain information about income inequality, consider a population of individuals in a static world who choose how many hours to work conditional on heterogeneous productivities and preferences over the consumption/leisure trade-off. To simplify ideas, assume productivity is equivalent to the hourly wage rate. In this canonical world, labor income inequality can first be decomposed into differences in hourly

> 1We will focus solely on labor income inequality throughout this paper.

> 2However, decomposing income inequality into productivities and preferences is not necessarily complete; if individuals have redistributive preferences which depend on the determinants of productivities and preferences, then a more complete decomposition of income inequality will be needed to assess the welfare benefits of redistribution. For example, individuals may have different tastes for redistribution if preference heterogeneity is mostly due to innate disutility of labor vs. disutility of labor due to poor health. Nonetheless, even if this is the case, our work is a useful step towards better understanding the sources of income inequality.

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