Tuesday, February 14, 2012

Substantially Less US Wage Inequality On An After-Tax Basis

The combination of the progressive tax rates of the US tax code with state income and sales taxes undoes a significant amount of US wage inequality on an after tax basis. State gasoline taxes make after tax wages more unequal and undo about 25 percent of the wage compression effect of state income and sales taxes.

From Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, DC, "Quantifying the Role of Federal and State Taxes in Mitigating Wage Inequality" by Daniel H. Cooper, Byron F. Lutz, and Michael G. Palumbo, January 12, 2012:
Overall, we find that the combined federal and state tax codes substantially mitigate wage inequality....On average, the compression achieved by state taxes is equal to only around 10 percent of the compression achieved by the federal tax code. This average effect, though, obscures economically meaningful differences across the states. In a few states, such as Minnesota, Oregon, and Wisconsin, state tax compression amounts to one-fourth to one-third of the compression brought about by federal taxes. On the other hand, the tax systems in thirteen states—including some large states such as Florida, Texas, and Illinois—actually widen the distribution of income. We find that the state-levied gasoline tax plays a surprisingly large role in the amount of compression across states. On average, it is estimated to offset roughly 25 percent of the income compression achieved by state income and general sales taxes. Our analysis also shows that exemptions for food and clothing from some states’ sales taxes play a quantitatively important role in narrowing the after-tax income distributions of these states.

Our second approach assesses the evolution over time of tax-induced income compression. We find that income compression due to federal and state taxes has risen mildly over the last 25 years. The rapid increase in before-tax labor income inequality documented widely by other researchers has thus been transmitted a bit less than one-for-one into after-tax labor income. Our analysis concludes by decomposing this increase in tax compression into the portion attributable to legislated changes in the tax code and the portion attributable to changes in the pre-tax distribution of earnings. We conclude that the increase in tax compression is more than explained by the latter. Specifically, the substantial increase in pretax wage inequality over this period interacted with progressive tax parameters to increase the amount of income compression caused by the tax system. We find that legislated changes to the tax code worked to offset some of this increase. That is, over time the tax code was adjusted to reduce income compression.

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