Using tax changes to reduce income inequality is a double-edged sword, according to research by Siddhartha Biswas, Indraneel Chakraborty and Rong Hai, published in the May 2017 issue of the Economic Journal.

Their study shows that raising the lower income end of the population with tax credits, for example, helps to boost economic growth, which is good news. But reducing the take-home pay of the upper income households hurts growth. The authors point out that policies that reduce income inequality, such as measures to improve education, do not have such trade-offs.

The researchers analyse three decades of US individual tax return data to drill down into how changing tax rates in the 50 states affect state-level growth. They focus on populations in the 10th and 90th percentile by income, rather than the 1st and 99th percentile, because they want to draw conclusions that apply to the larger cross-section of the population.

The key findings are that poverty alleviation helps three major components of growth: jobs, business and consumption. Women in lower income brackets choose to join the labour force if tax rates on the low-income population are low or even negative (for example, earned income tax credits). Small businesses, presumably in underprivileged communities, grow more. In addition, there is more consumption by lower income households, which is good for those families and the economy.

But if tax rates are increased on upper income households, the labour force participation of women in those households declines. Small businesses, which typically pay taxes at individual tax rates, also grow less and hire less. The result is overall lower growth.

The authors conclude that politicians and citizens need to be mindful of these headwinds and tailwinds created by tax policy on growth before using taxes to address income inequality. Tax rates need to balance social insurance while preserving economic incentives.

Exploring other avenues, such as providing better education and economic opportunities for everyone, may lead to better economic outcomes for everyone.

”Income Inequality, Tax Policy, and Economic Growth” by Siddhartha Biswas, Indraneel Chakraborty and Rong Hai is published in the May 2017 issue of the Economic Journal. Siddhartha Biswas is at the University of North Carolina. Indraneel Chakraborty and Rong Hai are at the University of Miami School of Business Administration.

Indraneel Chakraborty

http://indraneel.net/ | +1-312-208-1283 | indranil@alum.mit.edu