The Impact of Economic Growth, Tax Policy and Economic Freedom on Income Inequality

Article excerpt

Abstract

Considerable disagreement exists about how economic growth, taxes, and other policies affect the distribution of income from both a theoretical and empirical perspective. This short paper attempts to shed some light on the empirical debate about the role of tax policy in determining economic growth and the distribution of income.

JEL Codes: O4, E6

Keywords: Taxation, Economic growth, Economic freedom, Income distribution

I. Introduction

Considerable disagreement exists about how taxes and other economic policies affect the distribution of income from both a theoretical and empirical perspective. The received wisdom with regard to the impact of taxes on the distribution of income is fairly settled. Inasmuch as the tax system is progressive, it should serve to equalize somewhat the distribution of income in a society. Certainly, this is one of the major arguments in favor of progressive taxation, at least for those who value a more equal income distribution.

But there is theoretical debate. One complication is that economic policy, including tax policy, may impact economic growth as well as the distribution of income and that, in turn, economic growth and income inequality may be related. Disentangling these various forces is no easy task. This paper attempts to shed some light on the empirical side of the debate about the role of tax and other economic policies in determining the distribution of income.

II. Economie Growth

Modern growth theory comprises at least three competing strands. The neoclassical theory of economic growth, based on the work of Robert Solow (1956), focuses in the inputs of physical and human capital into the production process, and on technological advances, as the determinants of economic performance. Alternative explanations for growth are based on geographical factors. Jeffrey Sachs (2001), for example, argues that locational factors such as a temperate climate and access to markets are the keys to growth.

The institutional approach characterized by Douglass North (1990) emphasizes the importance of market institutions as the foundation for economic prosperity. Obviously, any discussion of the importance of tax policy on economic growth falls within this institutional approach. It is important to note that these three explanations for growth are not logically inconsistent with each other, so all might play a role, and any empirical examination of economic growth must attempt to control for all of these factors.

III. The Distribution of Income

It is assumed that progressive taxation should lead toward more income equality and regressive taxation should lead to more income inequality. Indeed, the static data on the distribution of income in the United States, for example, indicate that the after-tax distribution of income is more equal than the pre-tax distribution of income. This is consistent with the view that the U.S. has a progressive tax code that acts to equalize the distribution of income.

Despite this, many have suggested that it is difficult, if not impossible, to redistribute income via the tax code (or otherwise) in the long run. In the long run, the egalitarian effect of progressive taxes may be muted by various market adjustments. Let's say we attempt to use tax policy to redistribute income from one group of people to another. Market adjustments will lead to reduced supply and hence higher rates of return in the most-taxed areas, and increased supply and hence lower rates of return in the least-taxed areas. The ultimate impact on the distribution of income is likely to be much more limited as a result (Gwartney and Long, 1985). This is just another example of Gordon Tullock's (1975) transitional gains trap.

Simon Kuznets (1955) suggested that economic growth may involve a trade-off with income equality, so this dimension needs to be considered as well. But if various strands of economic theory indicate that (1) economic policy affects economic growth, (2) economic policy affects income equality, and (3) and economic growth affects income equality, it all gets very complicated. …