Research shows that state income taxes increase inequality by growing government

There are several reasons governments levy taxes. One, perhaps the most basic, is to pay for its functions, the police, military and the like. Another is to incentivize people not to do something, such as with ‘sin taxes’ on cigarettes. And the third is to redistribute income.

This third has grown in importance over the years. Nowadays, it is often argued that the government should take more money from one group of people to give it to another group. Taxation, on this argument, can reduce supposed inequalities of income and/or wealth.

But do they? A new paper from economist Ugo Troiano argues that, in fact, income inequality was increased by “the introduction of the state personal income tax, the introduction of tax withholding together with third-party reporting, and the intergovernmental agreements between the federal and state governments to coordinate tax auditing efforts”. Specifically (and technically),

My main finding is the following: the major tax reforms of the twentieth US increased the states’ economic inequality, regardless of the inequality measure used and of the specification. For instance, in a difference-in-differences specification that controls also for state specific linear trend, introducing the income tax raised the Atkinson index by 1.5 percentage points, 7 percent of its sample mean; introducing third party reporting and tax withholding raised the Atkinson index by 1.1 percentage points, about 6 percent of its sample mean; the audit information exchange agreement between the federal and the state governments raised the Atkinson index by 0.9 percentage points, which is about 4 percent of its sample mean.

This paper contributes to this literature by showing that, if the tax policy reforms of the twentieth century US were introduced to correct the inequality externality, they failed their intent, because inequality raised, instead of lowering.

Why does a policy enacted with the stated aim of reducing income inequality have exact opposite effect? Troiano dismisses several explanations as not fitting the data and concludes that

the fact that the only effect that these reforms had in common was raising the revenues from income tax and making the government bigger and the private sector smaller, suggest that a bigger government, at least in the recent history, had the effect of higher inequality.

The economist Milton Friedman said that we should judge policies on their effects, not their intentions. On this score, state income taxes have failed.

John Phelan is an economist at the Center of the American Experiment.