Tax Progressivity and Income Inequality

Abstract:     
This paper examines whether income inequality is affected by the structural progressivity of national income tax systems. Using detailed personal income tax schedules for a large panel of countries, we develop and estimate comprehensive, time-varying measures of structural progressivity of national income tax systems over the 1981-2005 period. We find that while progressivity reduces observed inequality in reported gross and net income, it has a significantly smaller impact on true inequality, approximated by consumption-based measures of Gini. We show theoretically and empirically that, under specific conditions, tax progressivity may increase actual inequality, especially in countries with weak law and order and a large informal nontaxable sector. The paper discusses implications of these results for increasingly popular flat tax policies. The Kuznets hypothesis is also supported by the estimates.

Keywords: income inequality, Gini, personal income tax, structural progressivity, tax evasion, redistribution, Kuznets hypothesis, democracy, law and order

JEL Classifications: H2, I3, J3, O1, O2

Working Paper Series