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Taxes and Inequality. Does Higher Progressivity of Income Taxation Lead to Less Inequality?

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Taxes and Inequality. Does Higher Progressivity of Income Taxation Lead to Less Inequality? Running head: Taxes and Inequality Taxes and Inequality. Does higher progressivity of income taxation lead to less inequality? A Thesis Presented to the Faculty of ISM University of Management and Economics in Partial Fulfillment of the Requirements for the Degree of Master of Financial Economics by Žilvinas Šilėnas May 2015 Taxes and Inequality 1 Abstract The paper explores theoretical and empirical evicence on whether progressivity of personal income taxation lead to less income inequality. The paper demonstrates that there is a lot of theoretical evidence, which question the simplistic notion that more progressivity lead to less inequality and vice versa. Paper provides comprehensive review of the spectrum of possible causal links between progressivity and inequality. Then the paper develops an empirical indicator to measure progressivity of personal income tax. It is used to estimate empirical relations between progressivity and income inequality in 27 European Union countries for the period of 2007-2013. The paper finds a weak relationship between a country being a flat-tax country and smaller reduction of income inequality measured by at-risk-of-poverty rate (but not with GINI inequality). However a statistical test finds no meaningful relationship between progressivity and reduction of at- risk-of-poverty income inequality. The paper concludes that it is impossible to find clear and unambiguous relationship between progressivity of income tax and income inequality. It suggests expanding the scope of research and including analysis of effects of transfer systems. Taxes and Inequality 2 Contents Introduction ............................................................................................................................ 5 Literature review ........................................................................................................................ 7 Terms and definitions used in this paper ................................................................................ 7 What is income inequality? ................................................................................................ 7 What is a progressive PIT? ................................................................................................. 8 Why would a more progressive income tax reduce indicators of inequality? ..................... 11 The composition of widely used indicators of inequality................................................. 11 Why do societies engage in redistribution and reduction of inequality ............................... 15 Review of academic literature .............................................................................................. 20 Relationship between inequality and progressive taxation ............................................... 20 The effect of progressivity of tax system on inequality ................................................... 26 Is less progressivity related to more inequality? .............................................................. 31 Other important factors and caveats ..................................................................................... 33 Conclusion and directions for empirical research ................................................................ 35 Methodology ............................................................................................................................ 37 Methodology for comparison between flat and progressive PIT ..................................... 37 Methodology for testing the relationship between progressivity and inequality.............. 38 Data ................................................................................................................................... 38 Construction of progressivity indicator of personal income tax (PIPIT) ......................... 43 Approach 1 – Linear approximation ................................................................................. 44 Approach 2 - Logarithmic approximation ........................................................................ 51 Approach 3 - GINI coefficient for PIT ............................................................................. 56 Empirical research and discussion ........................................................................................... 67 Do progressive PIT systems reduce inequality more than flat PIT systems? ...................... 67 Investigation of GINI data ................................................................................................ 68 Investigation of at-risk-of-poverty (AROP) data .............................................................. 73 Does higher progressivity reduce income inequality more? Comparison of countries with progressive PIT systems ....................................................................................................... 79 Conclusions .............................................................................................................................. 83 APPENDIX .............................................................................................................................. 90 Taxes and Inequality 3 List of figures Figure 1 Overview of most relevant findings in economic literature reviewed regarding causality, effect, and direction of the relationship between inequality and redistribution (progressivity) .......................................................................................................................... 36 Figure 2 Illustration of personal income tax (PIT) rates at different levels of income ............ 43 Figure 3 Results of R squared for PIPITLIN of 2012 data ........................................................ 46 Figure 4 Indicators of progressivity of PIT rates for EU countries with a progressive PIT rate system (in ascending order) using linear estimations .............................................................. 47 Figure 5 Indicators of progressivity of PIT rates for EU countries with a progressive PIT rate system. Arranged from most progressivity to least progressivity according to PIPITLIN values .................................................................................................................................................. 48 Figure 6 Changes in PIPITLIN 2012 -2014 and factors behind the changes............................. 49 Figure 7 Detailed illustration of PIT brackets, rates and PIPITLIN values for select countries 51 Figure 8 PIPITLOG vales using logarithmic estimation for years 2012 and 2014* .................. 52 Figure 9 PIPITLOG values using logarithmic approximation for France, Luxembourg and Portugal; 2012 and 2014 .......................................................................................................... 53 Figure 10 Comparisons of changes in PIT structures in Malta and Slovenia .......................... 54 Figure 11 Comparison of Linear and Logarithmic PIPIT. Minimum, maximum values, standard deviation .................................................................................................................... 54 Figure 12 PIPITLOG values using logarithmic estimation for years 2012 and 2014 ................ 55 Figure 13 Conceptual representation of GINI coefficient for PIT ........................................... 57 Figure 14 Conceptual representation of calculating area between income brackets and EIPITR ..................................................................................................................................... 58 Figure 15 PIPITGINI area with EIPITR of 300.000 Euro .......................................................... 61 Figure 16 PIPITGINI area with EIPITR 100.000 Euro .............................................................. 61 Figure 17 Values of PIPITGINI with EIPITR of 300.000 Euro and 100.000 Euro (in ascending order) ....................................................................................................................... 62 Figure 18 Percentage difference between PIPITGINI with EIPITR of 300.000 Euro and PIPITGINI with 100.000 Euro* ................................................................................................. 63 Figure 19 Difference in SOR score and income bracket gap between 300.000 EUR and top PIT bracket ............................................................................................................................... 64 Figure 20 Difference in SOR score and top PIT rate ............................................................... 64 Figure 21 Examination of changes in PIT structure and capture of the effects by PIPITGINI .. 65 Figure 22 Difference between Eurostat and Euromod data for AROP and GINI values for countries with progressive and flat taxes ................................................................................. 68 Figure 23 GINI Income inequality measured before-taxes, after-taxes, and after-taxes & transfers .................................................................................................................................... 69 Figure 24 Average reduction of GINI income inequality by direct taxes in countries with flat and progressive PIT systems. Comparison of average GINI inequality before-taxes and after- taxes (but before transfers). Reduction measured in percent and absolute value. ................... 72 Figure 25 Summary of distribution of flat PIT countries throught terciles of GINI inequality of income before-taxes and after-taxes** ...............................................................................
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