Effects of Tax Shocks on Inequality: Empirical Evidence from the United Kingdom

This study investigates the impact of discretionary tax cuts on income and consumption inequality in the United Kingdom. Using granular survey data from approximately 340,000 households, we construct quarterly inequality measures spanning 1970 to 2020 to assess the heterogeneous effects of exogenous tax shocks on income and consumption distributions. Employing a structural VAR framework, we find that tax cuts increase inequality in the UK. Specifically, a 1 percent tax cut leads to a 2 percent rise in the Gini coefficients of gross income and consumption within a year, with these effects persisting for nearly three years. The rise in inequality is primarily driven by increased labour earnings from full-time and part-time employment among middle- and high-income households, while low-income households experience a slight negative impact due to reduced social security income. Additionally, temporary reductions in VAT induce a short-term decline in CPI inflation, disproportionately boosting consumption among wealthier households. These findings highlight the unequal distributional effects of tax policy and its implications for inequality dynamics.