Taxation of Human Capital and Wage Inequality: A Cross-Country Analysis

Abstract

Wage inequality has been significantly higher in the U.S. than in continental European countries (CEU) since the 1970s. Moreover, this inequality gap has further widened during this period as the U.S. has experienced a large increase in wage inequality, whereas the CEU has seen only modest changes. This article studies the role of labour 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 human capital 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 labour 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 U.S. 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 U.S. 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.