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Tax reforms and inequality: theoretical and empirical implications

  • Theo Eicher
  • Stephen Turnovsky
  • Maria Carme Riera i Prunera

    (Universitat de Barcelona)

In this paper we examine the effect of tax policy on the relationship between inequality and growth in a two-sector non-scale model. With non-scale models, the longrun equilibrium growth rate is determined by technological parameters and it is independent of macroeconomic policy instruments. However, this fact does not imply that fiscal policy is unimportant for long-run economic performance. It indeed has important effects on the different levels of key economic variables such as per capita stock of capital and output. Hence, although the economy grows at the same rate across steady states, the bases for economic growth may be different. The model has three essential features. First, we explicitly model skill accumulation, second, we introduce government finance into the production function, and we introduce an income tax to mirror the fiscal events of the 1980s and 1990s in the US. The fact that the non-scale model is associated with higher order dynamics enables it to replicate the distinctly non-linear nature of inequality in the US with relative ease. The results derived in this paper attract attention to the fact that the non-scale growth model does not only fit the US data well for the long-run (Jones, 1995b) but also that it possesses unique abilities in explaining short term fluctuations of the economy. It is shown that during transition the response of the relative simulated wage to changes in the tax code is rather non-monotonic, quite in accordance to the US inequality pattern in the 1980s and early 1990s. More specifically, we have analyzed in detail the dynamics following the simulation of an isolated tax decrease and an isolated tax increase. So, after a tax decrease the skill premium follows a lower trajectory than the one it would follow without a tax decrease. Hence we are able to reduce inequality for several periods after the fiscal shock. On the contrary, following a tax increase, the evolution of the skill premium remains above the trajectory carried on by the skill premium under a situation with no tax increase. Consequently, a tax increase would imply a higher level of inequality in the economy.

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Paper provided by Universitat de Barcelona. Espai de Recerca en Economia in its series Working Papers in Economics with number 82.

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Length: 35 pages
Date of creation: 2002
Date of revision:
Handle: RePEc:bar:bedcje:200282
Contact details of provider: Postal: Espai de Recerca en Economia, Facultat de Ciències Econòmiques. Tinent Coronel Valenzuela, Num 1-11 08034 Barcelona. Spain.
Web page: http://www.ere.ub.es

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  1. Roberto Chang, 1995. "Political party negotiations, income distribution, and endogenous growth," Working Paper 95-3, Federal Reserve Bank of Atlanta.
  2. Felder, Stefan, 1997. "Tax Reform in a Two-Class Growth Model," Empirical Economics, Springer, vol. 22(2), pages 273-91.
  3. Galor, Oded & Tsiddon, Daniel, 1996. "Income Distribution and Growth: The Kuznets Hypothesis Revisited," Economica, London School of Economics and Political Science, vol. 63(250), pages S103-17, Suppl..
  4. Oded Galor & Joseph Zeira, 2013. "Income Distribution and Macroeconomics," Working Papers 2013-12, Brown University, Department of Economics.
  5. Cecilia Garcia Peñalosa, 1994. "Inequality and growth: a note on recent theories," Investigaciones Economicas, Fundación SEPI, vol. 18(1), pages 97-116, January.
  6. Kristin J. Forbes, 2000. "A Reassessment of the Relationship between Inequality and Growth," American Economic Review, American Economic Association, vol. 90(4), pages 869-887, September.
  7. Jason G. Cummins & Kevin A. Hassett & R. Glenn Hubbard, 1995. "Tax Reforms and Investment: A Cross-Country Comparison," NBER Working Papers 5232, National Bureau of Economic Research, Inc.
  8. Chiu, W Henry, 1998. "Income Inequality, Human Capital Accumulation and Economic Performance," Economic Journal, Royal Economic Society, vol. 108(446), pages 44-59, January.
  9. Jason G. Cummins & Kevin A. Hassett & R. Glenn Hubbard, 1994. "A Reconsideration of Investment Behavior Using Tax Reforms as Natural Experiments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 25(2), pages 1-74.
  10. Deininger, Klaus & Squire, Lyn, 1998. "New ways of looking at old issues: inequality and growth," Journal of Development Economics, Elsevier, vol. 57(2), pages 259-287.
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