Redistributive Policies through Taxation: Theory and Evidence

Increasing marginal tax rates and making payments to the poor reduce inequality and introduce savings dis-incentives. Using a heterogeneous agent model with incomplete markets, we show that higher taxes (and transfers) decrease consumption inequality but also mean savings and mean consumption. This demonstrates the trade-off between equity and efficiency. These theoretical predictions are tested by exploiting differences in tax rates across US states. Using two surveys, the Consumer Expenditure Survey and the Current Population Survey, we show that the empirical evidence supports the theory, and that there is a comparatively small fall in efficiency for a given gain in equity associated with higher taxation.