Taxation of Human Capital and Cross-Country Trends in Wage Inequality

Since the 1980's, wage inequality has increased substantially in the U.S. and U.K while changing little in most of continential European countries (CEU). This paper studies the effects of differences in labor income tax policies between US-UK and CEU for these trends. We begin by documenting three new empirical facts. First, we show that countries with a more progressive labor income tax schedule have significantly lower before-tax wage inequality at a point in time. Second, progressivity is also negatively correlated with the rise of wage inequality over time. Third, and finally, countries that experienced the smallest rise (or largest fall) in labor hours also had the smallest rise in wage inequality. We next construct a life-cycle model in which individuals decide each period whether to go to school, to work, or to be unemployed. Individuals can accumulate skills either in school or while working. Wage inequality arises from differences across individuals in their ability to learn new skills as well as from idiosyncratic shocks to human capital. In this framework, progressive taxation compresses the wage structure, thereby distorting the incentives to accumulate human capital, in turn reducing the cross-sectional dispersion of wages. When this economy experiences skill-biased technical change, progressivity dampens the rise in wage dispersion over time. Furthermore, these effects of progressivity are compounded by differences in average labor income tax rates: the higher taxes in the CEU reduces labor supply (and the benefit of human capital investments), further muting the response to SBTC. Consequently, as in the data, countries with higher average taxes and/or progressivity experience a larger fall in hours and a smaller rise in inequality. We estimate that differences in tax policies can account for 2/3 of the difference in the level and rise in wage inequality between US-UK and the CEU since 1980.