Taxation and Inequality: Active and Passive Channels

Abstract

This paper identifies and estimates two mechanisms by which the federal income tax system has affected consumption inequality between 1968 and 2010. In particular, we refer to changes in the tax system due to changes in the tax code as active and changes due to changes in income distribution as passive. To do this, we use data from 1968--2010, combine a structural macro-labor model of income and consumption processes with micro-simulations of taxation and decompose changes in the transmission of income shocks to consumption over this period. We find that (i) though the transmission of income shocks to consumption was partial and did not change much over the whole period, there were large changes in this transmission depending on periods, (ii) though the role of the federal income tax to smooth income shocks did not change much over the whole period, further decomposing the tax system reveals that active and passive tax policy changes counteract each other with a net tax effect that often obfuscates large changes in the role of tax policy, (iii) the overall transmission of income shocks is heterogeneous, falling relatively more on lower income groups and (iv) active and passive tax changes have heterogeneous impacts across income quartiles and education groups.

Keywords: Automatic stabilizers, personal income taxation, income risk, consumption, inequality

JEL Classification: D12, D31, D91, H24, E21