Income inequality and taxes – an empirical assessment

Economic literature offers several distinct explanations for the raising income inequality observed in several countries. In the debate about the causes of inequality a growing strand of research focuses on the effects of taxation on income inequality. We contribute to this literature by providing a systematic empirical account of the relationship between income inequality and personal income taxation (PIT) for a set of countries over the period 1981–2005. In order to take alternative explanations into account and to isolate the effects of tax progressivity, we include a wide range of control variables. We address potential reverse causality between inequality and PIT by using the variation in tax schedules of neighbouring countries. Our results confirm a statistically significant negative association between the progressivity of PIT and income inequality. Overall, we find that especially the average and the marginal tax rate have the potential to reduce income inequality. This finding is qualitatively robust across various different empirical specifications.