Staff Pick: Could More Progressive Taxes Increase Income Inequality?

This blog will periodically rerun posts of particular interest. The following is by Laura Jackson, Assistant Professor of Economics, Bentley University; Christopher Otrok, Research Fellow, St. Louis Fed; and Michael T. Owyang, Assistant Vice President and Economist, St. Louis Fed. It originally ran in May 2020 and explored the impact of progressive taxation.

In a previous post, we discussed how raising tax progressivity can be expansionary. Tax progressivity determines the incidence of taxes across people with different incomes. More progressive taxes mean higher income tax rates for high-income individuals and lower income tax rates for low-income individuals. 

In our paper "Tax Progressivity, Economic Booms, and Trickle-Up Economics,"Jackson, Laura E.; Otrok, Christopher; and Owyang, Michael T. “Tax Progressivity, Economic Booms, and Trickle-Up Economics.” Federal Reserve Bank of St. Louis Working Paper 2019-034A, November 2019. we computed a measure of tax progressivity jointly with a measure of the overall level of taxes. Thus, our measure minimized the amount that tax progressivity increases or decreases tax revenue, making it close to a pure reallocation of the burden of taxes.

Tax Progressivity and Income Inequality

In addition to exploring the effect of increasing tax progressivity on national economic growth, we examined the empirical effect of increasing tax progressivity on income inequality.

Our measure of income inequality is the difference between the 50th and 99th percentiles of the income distribution. We used this as our measure of income inequality as opposed to the more standard Gini coefficientThe Gini coefficient measures income concentration at each percentile of the population and ranges from 0 (perfectly equal) to 1 (perfectly unequal). For more on the Gini coefficient, see the Regional Economist article “Measuring Trends in Income Inequality.” because the tax incidence on very low-income quantiles is typically small.

An Increase in Income Inequality

We found that an increase in tax progressivity actually increases income inequality. At first, this result seems counterintuitive. Lowering taxes on low-income individuals and raising taxes on high-income individuals should make low-income individuals relatively better off: Disposable income for low-income individuals increases, thus allowing them to increase consumption.

How, then, would income inequality rise? Consider the standard fiscal multiplier story: Taxes decrease, consumption rises. But this consumption results in new income for others.

In the textbook example, everyone in the economy is the same. Thus, when taxes decrease, consumption rises for everyone, resulting in more income for everyone. This, in turn, leads to even more consumption for everyone.

We conjecture that inequality can rise if low-income agents work for (relatively) fixed wages but high-income agents own the stores and capital. When the low-income agents' taxes go down, they increase consumption at the stores owned by the high-income agents. Even though these high-income agents saw an initial decline in their disposable income from the tax shock, they see a countervailing rise in income from the new spending by the low-income agents.

If the high-income agents, in turn, increase their spending, they go to the stores owned by other high-income agents. The result is a multiplier effect that occurs only for the high-income agents and a single, one-time increase that occurs for the low-income agents. The net effect is that output rises, but the increase in income may trickle up to the top.

Notes and References

¹ Jackson, Laura E.; Otrok, Christopher; and Owyang, Michael T. “Tax Progressivity, Economic Booms, and Trickle-Up Economics.” Federal Reserve Bank of St. Louis Working Paper 2019-034A, November 2019.

² The Gini coefficient measures income concentration at each percentile of the population and ranges from 0 (perfectly equal) to 1 (perfectly unequal). For more on the Gini coefficient, see the Regional Economist article “Measuring Trends in Income Inequality.”