Elasticity determinants of inequality-reducing income taxation

Abstract

The link between income inequality and progressive taxation has long been considered a fundamental normative foundation for income tax progressivity. This paper furnishes necessary and sufficient conditions on primitives, in terms of the elasticity of income with respect to ability, under which various subclasses of progressive taxes are inequality reducing. The distributional effects of progressive income taxation are decomposed into two conditions on the wage elasticity of income, the tax rate effect and the subsidy effect, each capturing different aspects of the transition between before-tax and after-tax income distributions. The results confer a degree of useful flexibility to the theory, in that they allow the analyst to expand the universe of consumer preferences by suitably restricting the set of marginal-rate progressive taxes. As an illustration of the results’ practical implications, we provide a precise characterization of the subclass of (progressive) taxes that are inequality reducing for the constant elasticity of substitution (CES) and the quasi-linear utility functions.