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Income Inequality, Taxation, and Growth

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Abstract

Much recent theoretical and empirical research has focused on the relationship between income distribution and economic growth. The fiscal policy approach argues that inequality is linked to pressure for redistributionary taxation, leading to low capital investment and, therefore, growth. Empirical analyses are consonant with this view in that the long-run relationship between inequality and growth is negative. However, several empirical inconsistencies with the fiscal policy approach do emerge: (a) there exists a short-run, positive relationship between income inequality and growth and (b) the relationship between inequality and taxation is mixed, at best. This paper presents a simple theoretical model that reconciles the intuitively appealing fiscal policy approach with the empirical findings.

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Notes

  1. Note that the fiscal policy approach ignores dynamic issues such as the impact of expected future income mobility on preferences for redistribution (Bénabou and Ok (2001); Lambert et al. (2003); Quadrini (1999); Ravallion and Lokshin (2000)).

  2. Perotti (1996) uses a simultaneous equations approach to rule out potential reverse causation explanations, such as high growth countries preferring greater redistribution if inequality aversion is a normal good (Lambert et al. (2003)).

  3. The non-European countries in the sample are Australia, Canada, Israel, Taiwan, Russia and the US.

  4. Other mechanisms have been used to recognize group heterogeneity. For example, in Alesina and Drazen’s (1991) war of attrition model, the rich and poor incur different costs when stabilization is delayed. Laban and Sturzenegger (1994) assume that the rich have access to a “financial adaptation technology” (off-shore accounts), while the poor do not.

  5. In the extreme, all wealth would be appropriated (θ = 1). We assume, however, that the highest tax rate, \( \overline \theta \), is less than one and depends on country-specific norms. Alternatively, one could complicate the model by incorporating the possibility of upward mobility between periods. As a result, the median voter may prefer a tax rate less than one if there is a possibility he may end up wealthier than average in the second period. We abstract from such issues at this time.

  6. If a collective action argument were to be relied upon, the idea that wealthy individuals may be able to act collectively to achieve a common goal, while the poor are unable, is not new. Olson (1965) argues that certain sub-groups of the population are better able to organize collectively. This logic has been used to explain how the wealthy are able to avoid the location of pollution-generating activities and hazardous waste sites in areas in which they reside (e.g., Brooks and Sethi (1997); Arora and Cason (1999)). Elster (1989) and Ostrom (1998) emphasize the vital role played by social norms in the provision of public goods. Additionally, a more complicated alternative model could have the rich acting collectively in order to provide a public good—the absence of redistribution.

    The solution here parallels the command optimum solution of Fischer (1980) where, if the private sector acts cooperatively, taxes on capital will be low; if they act non-cooperatively, taxes on capital will be high. That is, Fischer (1980) shows that if the private sector is induced to save the right amount in the first period, the command optimum is attainable.

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Acknowledgements

The authors wish to thank Enrico Spolaore, David Weil, John Driscoll, Herschel Grossman, Oded Galor, and participants in the Brown University Macro Lunch for comments on an earlier version of the paper. The paper benefited from the comments of the anonymous referees. All errors are our own.

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  1. Gabelli School of Business, Roger Williams University, Bristol, RI, 02809, USA

    Maria Cornachione Kula

  2. Department of Economics, Southern Methodist University, Box 0496, Dallas, TX, 75275, USA

    Daniel L. Millimet

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Correspondence to Maria Cornachione Kula.

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Kula, M.C., Millimet, D.L. Income Inequality, Taxation, and Growth. Atl Econ J 38, 417–428 (2010). https://doi.org/10.1007/s11293-010-9244-0

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