Progressive tax increases income inequality

The progressive income tax system is designed to reduce the tax burden of those with a lower ability to pay and shift the burden increasingly to those with a higher ability to pay. Thus, it is commonly believed that an increase in tax progressivity will shift the burden of taxation from the poor to the rich. While most experts agree that higher progressivity reduces economic growth, they remain divided as to whether tax progressivity reduces inequality or even have any effect on inequality whatsoever. On one hand, some researchers found that by discouraging human capital investments, tax progressivity leads to higher inequality. Caucutt et al. (2003) show that reductions in the progressivity of labor income tax can positively affect growth and, furthermore, that “a less progressive tax system, which is rarely perceived as an egalitarian measure, gives rise to increased growth, decreased inequality, and greater mobility for the poor in the long run.” This mobility up the ladder of success is caused by the increased incentive for human capital accumulation.7 Meanwhile, Heathcote, Storesletten and Violante (2010) find that even if a progressive tax succeeds in reducing inequality, such policies can have a negative effect on welfare. For example, more progressive taxation dissuades individuals from acquiring additional education more than under a flat tax. This is because the expected income increase due to additional education would be taxed less, and therefore more valuable.8 Gimenez and Pijoan-Mas (2006) find that more progressive tax reform reduces economic output by 2.6 percent but results in a more egalitarian after-tax income distribution.9 Ventura (1999) also concludes that changes from tax progressivity to a flat-tax regime can bring about large gains in output and productivity at the expense of significant increases in inequality.10 Erosa and Korkeshova (2007) find that although progressive income taxes can reduce inequality, they have a negative effect on output.11 Others have found that tax policy has little impact on inequality. Sarte (1997) highlights that since individuals are endowed with different rates of impatience, they face a different rate of return on both human and physical capital leading to income dispersion. It is because individuals have different rates of impatience that some states are more unequal than others and not necessarily because of their tax regime. As a result, higher top marginal tax rates seem more effective at reducing economic growth than at reducing the degree of long-run income inequality.