The Effect of Inequality on Redistribution: An Econometric Analysis

Using data on U.S. state and federal taxes and transfers over a quarter century, we estimate a regression model that yields the marginal effect of any shift of market income share from one quintile to another on the entire post tax, post-transfer income distribution. We identify exogenous income distribution changes and account for reverse causality using instruments based on exposure to international trade shocks, international commodity price shocks and national industry demand shocks, as well as lagged endogenous variables, with controls for the level of income, the business cycle and demographics. We find the degree of attenuation of market income shifts initially increases in quintile rank, peaks at the middle quintile and then falls for higher income quintiles, consistent with median voter political economy theory and what Stigler called Director’s Law. We also provide evidence of considerable and systematic spillover effects on quintiles neither gaining nor losing in the “experiments,” also favoring the middle quintile, what we label the greedy median voter. “Voting” and “income insurance” coalition analyses are presented. We find a strong negative relationship between average real income and redistribution and a modest effect of two year led inequality.