Tax Progressivity and Income Inequality

In thinking about the merits and faults of the VAT, I came across some interesting data. The first source is a paper by Timothy Smeeding entitled “Public Policy and Economic Inequality: The United States in Comparative Perspective“. Professor Smeeding used a unique data set from a project called the Luxembourg Income Study to gain various perspectives on differences in income inequality across developed countries and over time. The result that I found most interesting in the context of thinking about the VAT was his calculation of income inequality both before and after taxes. The graph below presents his results.

Notes: The Gini coefficient is measured from 100 (complete inequality) to 0 (total equality).
Figures are from the mid- to late-1990s, depending on the country. See Smeeding’s paper for details.

The striking thing to me is how little the US’s tax code changes income inequality in the US. Yes, the US tax code is progressive, so that disposable income after taxes is a bit less unequal than it was before taxes… but the progressivity of the US tax code is quite modest compared to other developed countries.

Pairing this result with the tax structure of other developed countries thus reveals an important point, which I briefly mentioned in my previous post about the VAT: having a VAT doesn’t mean that the tax code need be regressive. And conversely, the absence of the VAT doesn’t meant that you have a progressive tax code.

The following table ranks the countries in the graph by how much their tax codes reduce income inequality (the first column). The other columns give a broad sketch of how taxes are raised in other countries: the proportion of taxes raised through consumption taxes and income taxes, the VAT rates, and the maximum marginal tax rate on income.

Sources: The first column’s data is from Smeeding; the rest from the OECD Tax Database.
Note: Tax data for the year 2002.

All developed countries collect more – usually far more – of their tax revenue through consumption taxes than does the US. Yet their tax codes are far more progressive. And surprisingly, other countries do not create that tax code progressivity by simply levying high marginal income tax rates on the rich; in general, their top rate is on par with that of the US. Instead, they generate progressivity in the tax code through generous low-income tax exemptions or credits, and top marginal tax rates that kick in at much lower levels of income than in the US.

I take two major lessons from this data. First, the lack of progressivity in the US tax structure is striking, and in my opinion, disgraceful. For those who think something needs to be done to ameliorate the US’s income inequality problem, making the tax code more progressive should clearly be one of the first lines of policy attack. There’s a tremendous amount of room for improvement there.

Secondly, the data suggests that the degree of progressivity of a country’s taxes is determined not by the mix of types of taxes collected, but rather by the political will to make the tax system progressive. Countries that like a progressive tax code can make that happen regardless of whether they have a VAT, income taxes, social insurance taxes, or any other specific type of tax. And countries like the US that haven’t seemed to favor a particularly progressive tax system also are able to implement that preference despite the use of more income taxes and fewer consumption taxes.

I find this oddly reassuring when considering a VAT in the US. Every country that has implemented a VAT has been able to maintain a much greater degree of tax progressivity than the US. It seems very plausible that the introduction of a VAT in the US could therefore be paired with changes in income taxes to keep the US tax code as progressive as it already is.

That’s why I worry less about whether there is or isn’t a VAT in the US, and much more about trying to change other features of the tax code that could make the tax system far more progressive in the US. The tax code will be progressive or not regardless of the existence of the VAT, depending on how much political will exists to make it progressive. So developing that political will is exactly where I think we should focus our efforts in the fight against excessive income inequality.