Why do the wealthy have higher returns and savings rates? - The role of labor.

Empirical evidence shows that wealthier individuals have both higher financial returns and higher savings rates. This is, however, not in line with standard normative theory suggesting identical savings rates along the wealth distribution and portfolios with lower returns for the wealthy (Merton, 1971). We formally show that this puzzle can be solved by introducing flexible labor supply with leisure being a luxury good that is enjoyed more by the wealthy in line with empirical evidence. This model is also solved in a rich life-cycle setting with labor income risk, portfolio constraints, and a bequest motive to quantify the effects. We also show how this individual behavior amplifies wealth inequality.