The Effect of the TopMarginal Tax Rate on Top Income Inequality

Top income inequality, defined as the income gap within the top 1% income group, has been rising in the United States since the 1980s. Coinciding with this rise, the large reductions in the topmarginal tax rate exhibit a strong correlation with the increase in both top income inequality and top income shares. This paper identifies endogenous human capital accumulation as the link between changes in top marginal tax rates and increases in top income inequality. We develop an infinite-horizon, heterogeneous agent model, where human capital accumulation is endogenously characterized by a proportional random growth process which depends on the top marginal tax rate. If the top marginal tax rate decreases, the benefit of human capital accumulation effort will increase, thereby increasing the growth rate of human capital. Since this growth rate pins down the Pareto inequality measure of the top income distribution, a decrease in the topmarginal tax rate will lead to amore unequal Pareto income distribution, while simultaneously increasing every top income. The calibrated model finds that the reduction of the top marginal tax rate from 70% to 40% can account for nearly two-thirds of the increase in top income inequality and 68.4% of the increase in the top 1% income share between 1980 and 2010. ∗I am grateful to Chad Jones for his guidance and support throughout this project. I also thank Pete Klenow and JohnWeyant formany helpful comments and encouragement. I have benefited from discussions with Arthur Chiang, Juho Kim, Jeff Knott, Joo Eun Lee, Christos Makridis, Daniel Murray, Moojoong Ra, Francisco Santos and participants at the Stanfordmacro bag lunch seminar. I gratefully acknowledge financial support from the Samsung Scholarship Foundation. The most recent version of this paper is posted at http://www.stanford.edu/∼jiheekim