Working Paper: NBER ID: w15526
Authors: Fatih Guvenen; Burhanettin Kuruscu; Serdar Ozkan
Abstract: Wage inequality has been significantly higher in the United States than in continental European countries (CEU) since the 1970s. Moreover, this inequality gap has further widened during this period as the US has experienced a large increase in wage inequality, whereas the CEU has seen only modest changes. This paper studies the role of labor income tax policies for understanding these facts, focusing on male workers. We construct a life cycle model in which individuals decide each period whether to go to school, work, or stay non-employed. Individuals can accumulate skills either in school or while working. Wage inequality arises from differences across individuals in their ability to learn new skills as well as from idiosyncratic shocks. Progressive taxation compresses the (after-tax) wage structure, thereby distorting the incentives to accumulate human capital, in turn reducing the cross-sectional dispersion of (before-tax) wages. Consistent with the model, we empirically document that countries with more progressive labor income tax schedules have (i) significantly lower before-tax wage inequality at different points in time and (ii) experienced a smaller rise in wage inequality since the early 1980s. We then study the calibrated model and find that these policies can account for half of the difference between the US and the CEU in overall wage inequality and 84% of the difference in inequality at the upper end (log 90-50 differential). In a two-country comparison between the US and Germany, the combination of skill-biased technical change and changing progressivity of tax schedules explains all the difference between the evolution of inequality in these two countries since the early 1980s.
Keywords: Wage Inequality; Taxation; Human Capital; Cross-Country Analysis
JEL Codes: E62; H21; J24; J31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| progressive taxation (H29) | after-tax wage structure (J31) |
| after-tax wage structure (J31) | incentives for human capital accumulation (J24) |
| progressive taxation (H29) | before-tax wage inequality (J31) |
| before-tax wage inequality (J31) | wage inequality over time (J31) |
| progressive taxation (H29) | cross-sectional dispersion of before-tax wages (J31) |
| tax policies (H29) | overall wage inequality (J31) |
| tax policies (H29) | inequality at the upper end (D63) |