We show that the drop in the equity premium since the 1970s can partially be explained by the shifts in the level and composition of U.S. income inequality. To show it, we use a framework that extends the standard production-based Consumption Capital Asset Pricing Model by allowing for heterogeneity of agents, who differ in their ability to hold financial assets and their labor shares of income. The top income group, capital owners, own the firms and provide labor and the rest of the economy is populated by workers who consume their labor income and income from risk-free government and corporate bonds. Intuitively, an increase in the share of capital in income rises the riskiness of consumption and predicts higher equity premium. A rise in the share of capital owners' non-risky labor income leads to lower excess return. Time-series U.S. equity premium regressions and cross-country excess return comparison significantly and robustly validate predictions of the model. The quantitative experiment of shifting capital and labor income shares of capital owners explains one third of the observed reduction in the U.S. equity premium. The reason is that, during the last five decades, capital owners benefited from higher average growth in their non-risky labor income relative to the capital income.
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