The Nexus Between Income Inequality and Tax Composition: A Cross-Country Perspective

We perform an empirical analysis to investigate the relationship between income inequality and the tax composition of countries. We first group the countries with respect to the composition of their taxes on income and taxes on goods and services as a share of gross domestic product.The clustering method is employed to identify country groups.Then, we examine the effect of being in a category on the countries'income inequality represented by the Gini index.To deal with the endogeneity issue, we use the instrumental variable method in the analysis. We find that the composition of tax revenues of countries is associated with the Gini index and the countries that impose a higher tax on income relative to tax on goods and services expose a lower level of income inequality; whereas the countries that place a higher tax on goods and services expose a higher level of income inequality. As a policy implication, structuring an effective tax composition will ultimately help the economies reduce inequality. Understanding the potential of the distributive effect of fiscal policy will contribute to managing taxation tools better and thus improving economic development.