Skip to main content

Unequal inequalities: Do progressive taxes reduce income inequality?

Abstract

This paper analyzes the effect of changes in the structural progressivity of national income tax systems on observed and actual income inequality. Using several unique measures of progressivity over the 1981–2005 period for a large panel of countries, we find that progressivity reduces inequality in observed income, but has a significantly smaller impact on actual inequality, approximated by consumption-based Ginis. An empirical comparative analysis shows that the differential effect on observed versus actual inequality is much larger in countries with weaker legal institutions. We also find that structural progressivity has a greater equalizing effect in environments that support pro-poor redistribution. Substantial differences in inequality response to changes in top versus bottom rates are also uncovered.

This is a preview of subscription content, access via your institution.

Fig. 1
Fig. 2

Notes

  1. A recent paper by Lakner and Milanovic (2015) finds that global inequality declined during the period 1988 to 2008 even as within-country income inequality increased.

  2. The term structural progressivity denotes changes in the average (or marginal) tax rate along the income distribution.

  3. Duncan (2014) and Doerrenberg and Duncan (2013) address a similar question to ours using different datasets and empirical techniques. Duncan (2014) uses data from the Russian Longitudinal Household Survey to simulate the redistributive effects of the Russian 2001 personal income tax reform, while Doerrenberg and Duncan (2013) use data from a laboratory experiment to estimate the impact of tax rate changes on income inequality.

  4. It is important to emphasize that we focus on the personal income tax only. As such, any equity offsets that may come from other taxes such as the corporate income tax or sales taxes are not taken into account. In principle, policymakers could achieve the same level of income inequality by substituting reduced progressivity of the personal income tax with increased progressivity of the corporate tax.

  5. The empirical micro-literature on developing countries has long pointed out the unreliability of income measures in household budget surveys due to widespread underreporting and called for the use of consumption-based measures of inequality (e.g., see Deaton 1997; Milanovic 1999).

  6. We use the term avoidance to refer to all legal non-real responses to taxation such as income shifting, timing, and accounting responses. We acknowledge that evasion and avoidance are different, and our primary interest is in the tax evasion response. Because it is often difficult to distinguish evasion responses from avoidance responses empirically, we use the terms interchangeably from here on.

  7. We acknowledge that the level of evasion tends to be more prominent at both tails of the income distribution. However, this should not have any qualitative effect on our results as long as the responsiveness of evasion is relatively higher in the right tail of the income distribution.

  8. For example, Slemrod and Kopczuk (2002) and Kopczuk (2005) make the point that the elasticity of taxable income is a function of the characteristics of the tax system and is larger in environments with many evasion/avoidance opportunities.

  9. Meltzer and Richard (1981) develop a theoretical model of government spending and show that an expansion of political franchise freedom leads to greater redistribution and larger government. Gradstein and Milanovic (2004) survey a number of other studies with similar findings.

  10. The RED data are taken from papers published in the special issue on Cross Sectional Facts for Macroeconomists; Volume 13, Issue 1 (January 2010). It includes data from Canada, Germany, Italy, Mexico, Russia, Spain, Sweden, UK, and the USA.

  11. This represents less than 15 % of the sample. Alternatively, we impute missing net Gini using predicted values from the linear regression of net Gini on gross Gini, time period fixed effects, region fixed effect, standard macroeconomic variables (log of per capita GDP, log of population, government size, and inflation), and characteristics of the country’s tax system such as the type of tax allowance (none, standard, complex), an indicator for having local PIT taxes (no local tax, local tax is less than 5 %, and local tax is higher than 5 %), an indicator for having PIT surtaxes, and the number of tax brackets in quadratic form. The explanatory power of the model is fairly high (R-squared is 83 %). The results stay the same when the predicted net Gini is used instead of gross Gini, and the results are available upon request.

  12. We also remove a small number of outliers (less than 1 % of the sample) if the reported Gini coefficient deviates from its country-specific linear trend by more than 3 standardized residuals.

  13. We do not account for deductions, allowances, and credits that vary by individual characteristics; for example, child credits are not included in our calculations.

  14. This corresponds to 4–200, 100–300, and 200–400 % of per capita GDP, respectively.

  15. While the between-countries standard deviation of the net income Gini is 11.6, the within-country standard deviation is only three points. Comparable numbers for the consumption Gini are 9.3 and 3, for between and within standard deviations, respectively.

  16. This allows us to control for time constant variables that are likely correlated with our measures of progressivity. We acknowledge that this approach does not fully solve the problem and is a limiting feature of the empirical analysis. It is worth noting that a similar approach is used by Dobson and Ramlogan-Dobson (2012) who use the same inequality measure as we do. Table 7 in Online Appendix A reports summary statistics for the covariates.

  17. We use financial sector deposit as a share of GDP and interest rate spread as our primary measure of financial development (Beck et al. 2000), and the ratio of deposit money bank assets to all bank assets (central bank plus money bank) as alternative measures in robustness checks. We also replace inflation rate with currency depreciation rate in robustness checks. These changes do not affect the results, which are available upon request.

  18. Table 9 in Online Appendix A presents results for the complete OLS and IV specification of the baseline model with MRP and ARP as measures of progressivity. The OLS estimates of progressivity are negative and statistically significant in ARP specification, but they are much smaller than the IV estimates, as implied in Sect. 4.1. The other coefficients are mostly consistent with expectations.

  19. We note that if consumption expenditures used in Gini estimates are disproportionately underreported among the rich, then the difference between consumption inequality and income inequality based on survey data will be smaller than the actual difference in inequality. This implies that the differential effect posited in hypothesis 3 based on true expenditures will be even bigger in absolute value than the effect we estimate. Our estimate in this case can be interpreted as a lower-bound estimate.

  20. Neighbors’ ARP-middle appear to be a weaker predictor for tax progressivity in the first stage compared to our other models (\(F\hbox {-stat}<4\)). We had to use additional instruments to make sure that IVs are valid before interpreting the results. The result in Table 5 is not affected by the use of two IVs; results are available upon request.

  21. The results reported in Table 6 are estimated without sample weights. The use of sample weights does not affect the results for corruption. However, the law and order results are somewhat sensitive to the inclusion of weights; sign and magnitude are similar, but estimates are imprecise in some specifications.

References

  • Adam, A., Kammas, P., & Lapatinas, A. (2014). Income inequality and the tax structure: Evidence from developed and developing countries. Journal of Comparative Economics, 43(1), 138–154.

  • Allingham, M., & Sandmo, A. (1972). Income tax evasion: A theoretical analysis. Journal of Public Economics, 1(3–4), 323–338.

    Article  Google Scholar 

  • Atkinson, A. B., & Brandolini, A. (2001). Promise and pitfalls in the use of ‘secondary’ data-sets: Income inequality in oecd countries as a case study. Journal of Economic Literature, 39(3), 771–799.

    Article  Google Scholar 

  • Beck, T., Demirg-Kunt, A., & Levine, R. (2000). A new database on financial development and structure. World Bank Economic Review, 14(3), 597–605.

    Article  Google Scholar 

  • Besley, T., & Case, A. (1995). Incumbent behavior: Vote-seeking, tax-setting, and yardstick competition. The American Economic Review, 85(1), 25–45.

    Google Scholar 

  • Borge, L.-E., & Rattso, J. (2004). Income distribution and tax structure: Empirical test of the Meltzer–Richard hypothesis. European Economic Review, 48(4), 805–826.

    Article  Google Scholar 

  • Bulr, A. (2001). Income inequality: Does inflation matter? IMF Staff Papers, 48(1), 139–159.

    Google Scholar 

  • Chong, A., & Gradstein, M. (2007). Inequality and institutions. The Review of Economics and Statistics, 89(3), 454–465.

    Article  Google Scholar 

  • Clarke, G. R. G., Xu, L. C., & Zou, H.-F. (2006). Finance and income inequality: What do the data tell us? Southern Economic Journal, 72(3), 578–596.

    Article  Google Scholar 

  • Clotfelter, C. T. (1983). Tax evasion and tax rates: An analysis of individual returns. The Review of Economics and Statistics, 65(3), 363–373.

    Article  Google Scholar 

  • Deaton, A. (1997). The analysis of household surveys: A microeconometric approach to development policy. Baltimore, MD: Johns Hopkins University Press.

    Book  Google Scholar 

  • Dhami, S., & Al-Nowaihi, A. (2007). Why do people pay taxes? Prospect theory versus expected utility theory. Journal of Economic Behavior and Organization, 64(1), 171–192.

    Article  Google Scholar 

  • Dobson, S., & Ramlogan-Dobson, C. (2012). Why is corruption less harmful to income inequality in Latin America? World Development, 40(8), 1534–1545.

    Article  Google Scholar 

  • Doerrenberg, P., & Duncan, D. (2013). Distributional implications of tax evasion: Evidence from the lab. Public Finance Review, 42(6), 720–744.

  • Duncan, D. (2014). Behavioral responses and the distributional effects of the russian ‘flat’ tax. Journal of Policy Modeling, 36(2), 226–240.

    Article  Google Scholar 

  • Easterly, W. (2007). Inequality does cause underdevelopment: Insights from a new instrument. Journal of Development Economics, 84(2), 755–776.

    Article  Google Scholar 

  • Egger, P., & Radulescu, D. M. (2009). The influence of labour taxes on the migration of skilled workers. The World Economy, 32(9), 1365–1379.

    Article  Google Scholar 

  • Engstrom, P., & Holmlund, B. (2009). Tax evasion and self-employment in a high-tax country: Evidence from Sweden. Applied Economics, 41(19), 2419–2430.

    Article  Google Scholar 

  • Feldstein, M. (1995). The effect of marginal tax rates on taxable income: A panel study of the 1986 tax reform act. Journal of Political Economy, 103(3), 551–572.

    Article  Google Scholar 

  • Ferede, E., & Dahlby, B. (2012). The impact of tax cuts on economic growth: evidence from the Canadian provinces. National Tax Journal, 65(3), 563–594.

    Article  Google Scholar 

  • Goni, E., Lopez, J. H., & Serven, L. (2011). Fiscal redistribution and income inequality in Latin America. World Development, 39(9), 1558–1569.

    Article  Google Scholar 

  • Gordon, R., & Li, W. (2007). Puzzling tax structures in devloping countries: A comparison of two alternative explanations, chapter 1 (Vol. 16). Chicago, IL: The University of Chicago Press.

    Google Scholar 

  • Gordon, R., & Li, W. (2009). Tax structures in developing countries: Many puzzles and a possible explanation. Journal of Public Economics, 93(7–8), 855–866.

    Article  Google Scholar 

  • Gorodnichenko, Y., Martinez-Vazquez, J., & Sabirianova Peter, K. (2009). Myth and reality of flat tax reform: Micro estimates of tax evasion response and welfare effects in russia. Journal of Political Economy, 117(3), 504–554.

    Article  Google Scholar 

  • Gorodnichenko, Y., Sabirianova-Peter, K., & Stolyarov, D. (2009). Inequality and volatility moderation in russia: Evidence from micro-level panel data on consumption and income. Review of Economic Dynamics, 13(1), 209–237.

    Article  Google Scholar 

  • Gradstein, M., & Milanovic, B. (2004). Does libert = egalit? A survey of the empirical links between democracy and inequality with some evidence on the transition economies. Journal of Economic Surveys, 18(4), 515–537.

    Article  Google Scholar 

  • Gravelle, J. G. (1992). Equity effects of the tax reform act of 1986. Journal of Economic Perspectives, 6(1), 27–44.

    Article  Google Scholar 

  • Imbens, G. W., & Angrist, J. D. (1994). Identification and estimation of local average treatment effects. Econometrica, 62(2), 467–475.

    Article  Google Scholar 

  • Kakwani, N. C. (1977). Measurement of tax progressivity: An international comparison. Economic Journal, 87(345), 71–80.

    Article  Google Scholar 

  • Kim, D.-H., & Lin, S.-C. (2011). Nonlinearity in the financial development-income inequality nexus. Journal of Comparative Economics, 39(3), 310–325.

    Article  Google Scholar 

  • Kleibergen, F., & Paap, R. (2006). Generalized reduced rank tests using the singular value decomposition. Journal of Econometrics, 133(1), 97–126.

    Article  Google Scholar 

  • Kleven, H., Landais, C., & Saez, E. (2013). Taxation and international migration of superstars: Evidence from the European football market. American Economic Review, 103(5), 1892–1924.

  • Kopczuk, W. (2005). Tax bases, tax rates and the elasticity of reported income. Journal of Public Economics, 89(11–12), 2093–2119.

    Article  Google Scholar 

  • Lakner, C., & Milanovic, B. (2015). Global income distribution: From the fall of the berlin wall to the great recession. The World Bank Economic Review (forthcoming).

  • Law, S. H., & Tan, H. B. (2009). The role of financial development on income inequality in malaysia. Journal of Economic Development, 34(2), 153–168.

    Google Scholar 

  • Lee, Y., & Gordon, R. H. (2005). Tax structure and economic growth. Journal of Public Economics, 89(5–6), 1027–1043.

    Article  Google Scholar 

  • Lemieux, T., Fortin, B., & Frechette, P. (1994). The effect of taxes on labor supply in the underground economy. American Economic Review, 84(1), 231–254.

    Google Scholar 

  • Martinez-Vazquez, J. (2008). The impact of budgets on the poor: Tax and expenditure benefit incidence analysis, chapter 5 (pp. 113–162). Washington, DC: World Bank.

    Google Scholar 

  • Meltzer, A. H., & Richard, S. F. (1981). A rational theory of the size of government. Journal of Political Economy, 89(5), 914–27.

    Article  Google Scholar 

  • Milanovic, B. (1999). Explaining the increase in inequality during transition. Economics of Transition, 7(2), 299–341.

    Article  Google Scholar 

  • Minarik, J. J. (1979). The size distribution of income during inflation. Review of Income and Wealth, 25(4), 377–392.

    Article  Google Scholar 

  • Mookerjee, R., & Kalipioni, P. (2010). Availability of financial services and income inequality: The evidence from many countries. Emerging Markets Review, 11(4), 404–408.

    Article  Google Scholar 

  • Musgrave, R., & Thin, T. (1948). Income tax progression, 1929–48. Journal of Political Economy, 56(6), 498–514.

    Article  Google Scholar 

  • OECD. (2011). International migration outlook: SOPEMI 2011. Paris: OECD Publishing.

    Book  Google Scholar 

  • Persson, T., & Tabellini, G. (2002). Political Economics and Public Finance (Vol. 3). Amsterdam: Elsevier.

    Google Scholar 

  • Sabirianova Peter, K., Buttrick, S., & Duncan, D. (2010). Global reform of personal income taxation, 1981–2005: Evidence from 189 countries. National Tax Journal, 63(3), 447–478.

    Article  Google Scholar 

  • Slemrod, J. (1985). An empirical test for tax evasion. The Review of Economics and Statistics, 67(2), 232–238.

    Article  Google Scholar 

  • Slemrod, J. (1994). On the high-income Laffer curve, chapter 6 (pp. 177–210). Cambridge: Cambridge University Press.

    Google Scholar 

  • Slemrod, J. (1995). Income creation or income shifting? behavioral responses to the tax reform act of 1986. The American Economic Review, 85(2), 175–180.

    Google Scholar 

  • Slemrod, J., & Kopczuk, W. (2002). The optimal elasticity of taxable income. Journal of Public Economics, 84(1), 91–112.

    Article  Google Scholar 

  • Suits, D. B. (1977). Measurement of tax progressivity. American Economic Review, 67(4), 747–752.

    Google Scholar 

  • Violante, G. (2010). Special issue: Cross-sectional facts for macroeconomists. Review of Economic Dynamics, 13(1), 1–264.

    Article  Google Scholar 

  • Whalley, J. (1990). Foreign responses to U.S. tax reform. Cambridge: MIT Press.

    Google Scholar 

  • Yitzhaki, S. (1974). Incometax evasion: A theoretical analysis. Journal of Public Economics, 3(2), 201–202.

    Article  Google Scholar 

Download references

Acknowledgments

We would like to thank participants at the 71st Annual Congress of the International Institute of Public Finance, and two anonymous referees for their feedback and suggestions.

Author information

Authors and Affiliations

Authors

Corresponding author

Correspondence to Denvil Duncan.

Ethics declarations

Conflict of interest

The authors declare that they have no conflict of interest.

Electronic supplementary material

Below is the link to the electronic supplementary material.

Supplementary material 1 (pdf 468 KB)

Rights and permissions

Reprints and Permissions

About this article

Verify currency and authenticity via CrossMark

Cite this article

Duncan, D., Sabirianova Peter, K. Unequal inequalities: Do progressive taxes reduce income inequality?. Int Tax Public Finance 23, 762–783 (2016). https://doi.org/10.1007/s10797-016-9412-5

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10797-016-9412-5

Keywords

  • Income inequality
  • Gini
  • Personal income tax
  • Structural progressivity
  • Tax evasion

JEL Classification

  • H2
  • I3
  • J3
  • O1
  • O2