Quantifying the Role of Federal and State Taxes in Mitigating Wage Inequality

Posted: 10 Feb 2012

See all articles by Byron F. Lutz

Byron F. Lutz

Federal Reserve Board - Research Division

Daniel Cooper

Federal Reserve Bank of Boston

Michael Palumbo

Board of Governors of the Federal Reserve - Flow of Funds Section; University of Houston - Department of Economics

Date Written: January 1, 2012

Abstract

Wage inequality has risen dramatically in the United States since at least 1980. This paper quantifies the role that the tax policies of the federal and state governments have played in mitigating wage inequality. The analysis, which isolates the contribution of federal taxes and state taxes separately, employs two approaches. First, cross-sectional estimates compare before-tax and after-tax inequality across the 50 states and the District of Columbia. Second, inequality estimates across time are calculated to assess the evolution of the effects of tax policies. The results from the first approach indicate that the tax code reduces wage inequality substantially in all states. On average, taxes reverse approximately the last two decades of growth in wage inequality. Most of this compression of the income distribution is attributable to federal taxes. Nevertheless, there is substantial cross-state variation in the extent to which state tax policies compress the income distribution. Cross-state differences in gasoline taxes have a surprisingly large impact on income compression, as do sales tax exemptions for food and clothing. The results of the second approach indicate that the mitigating influence of tax policy on wage inequality has increased very modestly since the early 1980s. The increase is due to the widening of the pre-tax wage distribution interacting with a progressive tax structure. In contrast, legislated tax changes over this period decreased income compression somewhat.

Keywords: Wage inequality, tax incidence

JEL Classification: H22, H71, J31

Suggested Citation

Lutz, Byron F. and Cooper, Daniel H. and Palumbo, Michael, Quantifying the Role of Federal and State Taxes in Mitigating Wage Inequality (January 1, 2012). FEDS Working Paper No. 2012-05. Available at SSRN: https://ssrn.com/abstract=2002023

Byron F. Lutz (Contact Author)

Federal Reserve Board - Research Division ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Daniel H. Cooper

Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States
617-973-4220 (Phone)

Michael Palumbo

Board of Governors of the Federal Reserve - Flow of Funds Section ( email )

Washington, DC 20551
United States
202-452-2296 (Phone)

University of Houston - Department of Economics ( email )

Houston, TX 77204-5882
United States

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