Tax Progressivity, Economic Booms and Trickle-Up Economics

We propose a method to decompose changes in the tax structure into orthogonal components measuring the level and progressivity of taxes. The level shock is similar to tax shocks found in the empirical literature--increasing the tax level is contractionary. On the other hand, an increase in tax progressivity is expansionary. When tax progressivity increases, the bottom of the income distribution experiences an increase in disposable income. Agents at the low end of the income distribution who have high marginal propensity to consume offset the decrease in consumption by the savers at the high end of the income distribution. In the medium term, the economic expansion benefits those at the top of the income distribution: Capital gains they experience from the boom offset income losses from the increase in tax progressivity. The net result is that an increase in progressivity leads to an increase in income inequality, contrary to what conventional wisdom might suggest. We interpret these results as evidence in favor of trickle up, not trickle down, economics.