Do redistributive state taxes reduce inequality?

INTRODUCTION

A Common contention in the public finance literature is that redistribution should occur primarily at the national level (Musgrave, 1959; Oates, 1972). According to this argument, if state or local governments attempt to impose redistributive income taxes, cross-state mobility will lead to a compensating increase in gross wages for high-skill workers. If full adjustment occurs, then net wages for low-skill and high-skill workers will be unaffected by the rise in redistributivity.

This argument suggests that more redistributive state taxes result in efficiency losses without achieving any net redistribution. If true, it suggests that states should focus on raising revenues in the most efficient manner possible, rather than attempting to redistribute between the rich and the poor. The hypothesis also has implications for labor market mobility within the European Union. Particularly between pairs of neighboring countries with a common language (e.g., France and Belgium; Germany and Austria; Britain and Ireland), a rise in tax redistribution in one country may merely lead to cross-border migration, driving up pre-tax inequality, and leaving post-tax inequality unchanged.

Using data from the 1983 and 1989 U.S. Current Population Survey (CPS), Feldstein and Wrobel (1998) find that when states implement more redistributive income tax systems, wages become more unequal (i.e., wages of high-skill workers rise by enough to offset the higher tax rates). They conclude that this adjustment process is rapid: controlling for the 1989 tax structure, tax rates in 1983 have no effect on gross wages in 1989. This is consistent with Blanchard and Katz (1992), who observe relatively rapid migration out of high unemployment areas in response to adverse demand shocks, with the unemployment rate returning to normal after a period of five to seven years.

Others, however, have found more modest effects. Focusing on the top end of the income distribution, and using annual tabulations of estate tax returns from 1965-1998, Bakija and Slemrod (2004) conclude that higher state sales taxes and inheritance/estate taxes have modest but significant negative impacts on the number of federal estate tax returns filed in a state. The rich do flee from higher state taxes, but the resulting deadweight loss is small relative to the revenue raised. This is consistent with Conway and Houtenville (2001) who use migration data from the 1990 Census to investigate the migration patterns of those aged 65 and over. They find that although the elderly are attracted to states with lower personal income and inheritance/estate taxes, the magnitude of the effect is small, and the results are sensitive to the particular specification chosen. (1)

Similarly, studies of welfare and the Earned Income Tax Credit (EITC) have not observed substantial effects at the lower end of the distribution. Cushing--Daniels (2004) uses the 1968-2002 Panel Study of Income Dynamics to study the impact of welfare generosity on mobility, and finds that benefits do not have a significant effect on cross-state migration. Leigh (2004) uses the 1989-2002 CPS to explore the impact of state EITCs on earnings, and concludes that only a small portion of the observed effect could have been due to workers moving into states with more generous EITCs.

From a theoretical standpoint, the extent to which the pre-tax wage distribution will adjust to offset the effect of redistributive taxes depends on the degree to which workers are willing to change location in response to taxes. As Mirrlees (1982) has shown, the optimal amount of redistribution by a particular jurisdiction is a declining function of the degree of mobility in response to taxes. This is generally interpreted to mean that there should be more redistribution at the national level than at the state level, and more redistribution at the state level than at the local level. But whether migration can entirely offset the redistributive effects of taxation at any particular level is ultimately an empirical question.

Since the sharpest empirical predictions about the effect of redistributive taxes on inequality relate to the distribution of hourly wages, this paper, therefore, focuses on hourly wage inequality. For expositional simplicity, I will often refer to this just as "inequality." (2) To assess the impact of redistributive taxes on gross earnings, I use the National Bureau of Economic Research's Taxsim program (Feenberg and Coutts, 1993) to create a measure of the redistributive effect of personal income taxes across U.S. states over the years 1977-2002. Separately calculating inequality from the March CPS over those same years, I find that more redistributive taxes are not offset by a rise in pre-tax inequality. Analyzing mobility, I do not find clear evidence that more redistributive taxes affect the volume or composition of interstate migration.

The remainder of this paper is structured as follows. The second section analyzes the impact of redistributive taxes on inequality, using a standard measure of the redistributive effect of taxation, and presents a number of robustness checks on this specification. The third section proposes a new class of tax redistributivity measures, based on the S-Gini, and uses these measures to see whether the effect of taxes on gross wages has a stronger effect on the top or bottom of the distribution. The fourth section studies the effect of redistributive taxes on migration, post-tax inequality, and incomes. The fifth section delves into the political economy of redistributive taxation, and the sixth section concludes.

HOW DO REDISTRIBUTIVE TAXES AFFECT THE PRE-TAX GINI COEFFICIENT?

To test the impact of redistributive taxation on inequality, Feldstein and Wrobel (1998) regress an individual's gross hourly wage on his or her average tax rate, using data from 1983 and 1989. Since the average tax rate is endogenous to hourly earnings, they instrument for the actual average tax rate with a predicted average tax rate, based on demographic characteristics.

A more reduced form approach, which will be implemented here, is to regress a measure of the distribution of hourly wages on a measure of tax redistribution, controlling for state and year fixed effects, and for certain time-varying state characteristics. If it is the case that more redistributive taxes raise the pre-tax hourly wages of high-skilled workers relative to low-skilled workers, there should be a positive relationship between redistributive taxes and hourly wage inequality.

Data are drawn from the March CPS, covering earnings in the years 1977-2002. Using these surveys, the redistributive effect of taxation and hourly wage inequality are separately estimated for each state and year. Over this relatively long time period, it is also possible to estimate different lag specifications, taking account of the possibility that it may take some time before the wage distribution fully adjusts to changes in taxation.

What is the appropriate measure of the redistributive effect of taxation? For simplicity, I adapt the Reynolds-Smolensky index (Reynolds and Smolensky, 1977), which simply measures the amount by which taxation changes the Gini coefficient for hourly wages. In its usual definition, the Reynolds-Smolensky index (RS) is the difference between the Gini coefficient for after-tax earnings (GA) and the Gini coefficient for before-tax earnings (GB), such that RS = GA - GB. To obtain a measure that is increasing with the redistributive effect, I swap the terms to obtain the index GB - GA. Using a measure of the redistributive effect of taxation that is based on the Gini coefficient makes it natural to measure hourly wage inequality using the Gini. In the third section, I explore the robustness of these results to the use of alternative measures of inequality.

The redistributive effect of taxation is different from the progressivity of taxes. The redistributive effect is a function of three parameters: the average tax rate, tax progressivity (the disproportionality of tax payments), and the re-ranking effect (which occurs when the tax system takes account of non-income differences). The three measures are discussed and related to one another in Creedy (1999). For the purposes of considering the impact that taxes have on the distribution of wages, what matters is the redistributive effect, since this fully encapsulates the effect of the tax system on the distribution of incomes, regardless of whether that effect is due to changes in the average tax rate, progressivity, or re-ranking.