WHY DO THE RICH SAVE MORE? A THEORY AND AUSTRALIAN EVIDENCE *

We provide a theory to explain the existence of inequality in an economy where agents have identical preferences and have access to the same production technology. Agents consume a “utility ” good and a “health ” good which determines their subjective discount factor. Depending on initial distribution of capital the economy gets separated into different permanent-income groups. This leads to a testable hypothesis: “The rich save a larger proportion of their permanent income”. We test this implication for the savings behaviour in Australia. We show that even after controlling for life-cycle characteristics permanent income and savings are positively correlated. An improvement in the health is associated with higher savings rates and better saving habits