We examine the quantitative importance of financial market shocks in accounting for business cycle fluctuations. We emphasize the role financial markets play in reallocating funds from cash-rich, low productivity firms to cash-poor, high productivity firms. Using evidence on financial flows at the firm level, we find that for publicly traded firms (in Compustat), almost all investment is financed internally. However, using an alternative data source (Amadeus), we find that most investment by privately held firms is financed via external funds. Motivated by these observations, we build a quantitative model featuring publicly and privately held firms that face collateral constraints and idiosyncratic risk over productivity as well as non-financial linkages. In our calibrated model, we find that a shock to the collateral constraints which generates a one standard deviation decline in the debt-to-asset ratio leads to a 0.5\% decline in aggregate output on impact, roughly comparable to the effect of a one standard deviation shock to aggregate productivity in a standard real business cycle model. In this sense, we find that disturbances in financial markets are a promising source of business cycle fluctuations when non-financial linkages across firms are sufficiently strong.
This paper studies the determinants of optimal taxes for wealthy individuals faced with capital income risk. I develop a model of optimal taxation of capital income in which wealth and income inequality is a result of capital income shocks together with frictions in ?nancial markets. I use the model to study optimal taxation of various types of capital income: capital income from controlled businesses, outside the business as well as bequests. In presence of risk-return trade-offs, i.e., when more productive investments are riskier, I show that it is typically optimal to have progressive saving taxes. Furthermore, in an intergenerational context, I show that bequest taxes should be negative. Finally, I study the implications of the model on long run ef?cient distribution of wealth. I show that the long-run distribution of wealth has a fat-tail distribution and compare the ef?cient tail of the wealth distribution to the one resulting from an ad-hoc incomplete market model.