Rethinking Tax Systems: How Heterogeneous Tax Mix Shapes Income Inequality in European OECD Economies

Divergences in tax policies are evident among European OECD economies, due to varying priorities of efficiency vs. equity, influenced by the forms of direct vs. indirect taxation. The special interest of this paper is to identify how different tax forms (direct—corporate and personal income taxes (CIT, PIT); and indirect—value added tax (VAT)) affect inequality in European OECD economies in the period 2003–2020. Using heterogeneous non-stationary panel models and the (Pooled) Mean Group (PMG/MG) methods of estimation, a long-run negative relationship between direct tax forms (CIT, PIT) and the Gini coefficient was discovered, meaning that utilizing progressive direct tax forms resulted in more equity. The error-correction terms are heterogeneous, showing that developed economies decrease income inequality by using direct taxes more efficiently than emerging European OECD economies. The short-run statistically significant relationships between VAT and the Gini coefficient are discovered, meaning that certain European OECD economies effectively use VAT revenue to achieve greater equity in society. This study demonstrates that the use of indirect tax forms may be beneficial in terms of collecting more tax revenues, and that using them for redistributive programs can reduce inequality while maintaining economic efficiency.