February 02, 2018
Activities /
Posted by NCID

What determines the level of taxation and redistribution in a democratic political environment? Recently, United States’ President Donald Trump proposed the largest tax overhaul in decades. Some argue that this measure is predicted to mostly benefit those in the upper income quintile, therefore increasing inequality. Perhaps, this contrast the period between the 1950s and the 1980s when we saw a clear increase in the welfare state in the U.S. 

Generally, economists believe that higher inequality fosters pressures to increase taxes and redistribution. While it is true that inequality has been an essential factor in shaping current fiscal policy, there are other factors to be considered. Ignacio Campomanes, a PhD candidate from the University of Minnesota, introduces social mobility and tax evasion to study inequality and fiscal policy, in his paper The Political Economy of Inequality, Mobility and Redistribution

Campomanes divides people into rich and poor and uses a two-type model for his study. First, he analyses social mobility in a society. “Everybody is born to a family, which can be rich or poor, and this directly tends your endowment. The probability of being born to a rich family and being rich is more than half, as well as the probability of being born to a poor family and being poor is more than half too”, he explained. His model predicts that incentives for the rich-types to pay taxes will crucially depend on the degree of social mobility. Intuitively, in a more mobile society, the rich insure against the probability of being poor by paying taxes, increasing redistribution. Conversely, if the rich-types know they will always be rich, then they will have no incentives to pay taxes, thus redistribution decreases. Both effects are markedly stronger when inequality is higher. 

In this context, his study finds that there is a strong positive correlation between social mobility and redistribution. “Around 80 percent of an increase in pre-tax inequality is offset by higher redistribution in the most mobile societies, whilst this effect dissipates to only of 10-20 percent in the less mobile societies”, showed Campomanes.

Therefore, Campomanes studies how to come up with a fiscal policy where the taxes are the highest possible without incentivising tax evasion from the rich. “The poor are always going to comply, also because they are going to receive a net transfer from the system”, he said.  “For the rich this is going to depend on the tax rate”. 

As taxes rise the utility increases for the poor while it decreases for the rich. After a certain threshold, the rich are indifferent to compliance or evasion. This is the highest tax possible in which “[the] rich still comply.”