Reducing Inequality via Taxation Reforms - a Macroeconomic Analysis

Abstract: Since the 1980s income and wealth inequality has been increasing in Europe and the United States. This paper examines taxation reform scenarios to reduce inequality in Germany, while simultaneously observing the effects on macroeconomic variables. I employ an incomplete markets model, where households face uninsurable idiosyncratic income risk and choose labor endogenously. The stochastic earnings process, generating the income and wealth distribution, is calibrated to match German data in 2011/2012. Comparing reforms in capital tax, income tax and consumption tax, I find increasing income taxes to achieve the most redistribution, yet paired with substantial economic distortion. Weighing distributional benefits against economic distortions, higher consumption taxes do best in reducing inequality in an efficient way. However, raised consumption taxes redistribute evenly over the distribution, while higher capital taxes constitute a targeted measure, redistributing mostly from the top 20% to the bottom 20%.