The Impact of Tax on Income Inequality

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from NCPA,

Income inequality has risen dramatically in the United States since at least 1980. The tax policies of the federal and state governments are a potential compensating factor in the rise in income inequality, particularly as they relate to progressivity or the rate at which taxes rise with income.

Decomposing the effect of taxes on income inequality into the impact of federal versus state tax policies, federal taxes are, on average across the states, responsible for all of compression of the net income distribution relative to the gross income distribution. In addition, despite significant heterogeneity across states to the extent of before-tax inequality, there is also no variation across states in terms of the amount of federal compression.

– About one-half of the states have progressive tax systems that compress income inequality. States such as Oregon, Minnesota and Wisconsin obtain the greatest degree of compression. The states with the most progressive tax systems tend to have below average pre-tax income inequality.
– In contrast, one-half of the states have tax structures that appear to increase income inequality and effectively offset some of the progressive nature of the federal tax code. The tax systems in Mississippi, Louisiana, Tennessee and West Virginia are among the most regressive. The states with the most regressive tax systems have above average pre-tax inequality.

The overall progressive structure of federal taxes tends to mitigate income inequality across households to a substantial extent in all U.S. states. However, state-levied taxes, on average, work to exacerbate income inequality. Looking at average state tax compression, however, masks significant heterogeneity across states.

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