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Of all the papers I've written, this one is my favorite.
It derives a very simple theory of the relationship between development
and inequality from Solow's (1956) classic model of economic growth.
To put the paper in context, in the United States, income inequality has been rising for decades:
And the effects of that increase in inequality have been acutely felt
in the past few years as average income has risen, while median
income has fallen:
In fact, the poorest 60 (sixty!) percent of householdssaw their real incomes decline between 1999 and 2006. How are we to understand these developments?
The model developed in the paper asserts that tax policy may explain
some of the differences in income inequality among states.
According to the model, steady-state income inequality
depends entirely on household saving rates. Relatively high-saving
households accumulate more capital than relatively low-saving
households and therefore have higher steady-state income.
Households are assumed to save
out of disposable income, so raising tax rates reduces household saving
rates and causes the economy to converge to a lower steady-state level
of average income. Different forms of taxation have different effects
on inequality however.
Taxation of
labor income causes a larger percentage decline in the saving rates of
relatively low-saving households, thus increasing steady-state income
inequality. By contrast, taxation of capital income has the opposite
effect: it causes a greater percentage decrease in the saving rates of
relatively high savers, thus reducing steady-state income
inequality.
Data from the March CPS and the NBER's TAXSIM provides some empirical
support for the model. Higher wage taxes are associated with a
greater degree of inequality, even when the regression model includes
educational inequality as a control for the fact that a tax on wages
taxes the returns to both labor and human capital.
Of course, taxation of wage income taxes the returns to both labor and
human capital, but given the fact that most people invest in their
educations before entering the labor force, it seems likely that the marginal effect on labor is much stronger than the marginal effect on human capital.
A high degree of collinearity among the tax rates and the various forms
of capital income taxation prevent us from discerning the empirical
sign of taxes on capital income, but taxes on long-term gains, which
exhibit the lowest degree of correlation with the other tax rates, are
associated with lower inequality (as predicted by the theoretical
model).
Although the model and empirical evidence strongly suggest that tax
policy has a role to play in shaping the distribution of income, I do
not believe that tinkering with the tax code should be the only
response to the increase in income inequality.
The whole point of the paper is that if we can encourage low income
people to save more, we can bring the economy to a higher level of
economic development and reduce the degree of income inequality.
Tax policy
should be changed to encourage low-income families to save more, but
that should not be the only policy response. We should also look deeper to
find the fundamental reasons why some households save more than others
and try to find ways to address the causes of low saving.
For example, if we interpret capital as human capital
and if human capital is acquired through education, then reducing high school dropout rates will raise the "saving rates" of low-income households and reduce steady-state income inequality.
In future research, I plan to identify the characteristics of people who
move up the income ladder (i.e. people who increase their saving rates)
and find out if there's a way to "give" those characteristics to
people who
otherwise would not move up the income ladder.
References
R. M. Solow. "A Contribution to the Theory of Economic Growth." Quarterly Journal of Economics, 70(1):65–94, Feb. 1956.