Personal Income Tax and Income Inequality. New Evidence from a South American Country: Ecuador 2007-2011

Abstract

This paper assesses the redistributive impact of Ecuador’s personal income tax (PIT) over the 2007-2011 period. First, using individual income tax return data we compute different indicators of tax progressivity and redistributive impact (i.e. Kakwani, Suits and Reynolds-Smolensky indices) to estimate the extent to which income inequality is modified by the PIT. Second, we mobilize microsimulation techniques to assess the redistributive effect of the PIT while testing different definitions of taxable income. Third, based on the top incomes literature, we compute the effective income tax rates paid by top income groups. Finally, based on the elasticity of taxable income literature, we derive optimal income tax rates for top income groups. We find two main empirical results. First, although Ecuador’s PIT is highly progressive its redistributive capacity is very low because high-income individuals are more likely to reduce their taxable income through legal tax deductions than low-income individuals. Second, the effective tax rates paid by high-income individuals are relative low (e.g. 7% for the top 1% group) while optimal tax rates for top earners could be as high as 63%.