What would most likely happen if the government increased payroll taxes?

What would most likely happen if the government increased payroll taxes. Economic inequality is one of the hot debates in today’s society. In addition, everything indicates that the covid-19 crisis could be an amplifier of this inequality through various channels. Labor market, disconnection between markets and the economy. For this reason, governments are looking for ways to reduce it through. A progressive tax system in which the highest incomes are intended to pay more than the lowest incomes. An objective that can even have positive effects on economic growth. Not if the tax increases are implemented in the middle of a recession, then the impact on the economy can be fatal. Furthermore, and although it may seem absolutely contradictory, a more progressive tax system may end up increasing economic inequality.

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Laura E. Jackson, Christopher Otrok, and Michael T. Owyang, economists at the research department of the Federal Reserve Bank of San Luis, conclude in a new study that a more progressive tax system may end up increasing the income of the richest, who are the who receive to a greater extent income from capital (dividends, rents…) .

In addition, a tax increase in the middle of a recession can prolong and deepen the economic crisis, since it reduces the disposable income of households in a context of great uncertainty and declining activity. A fall in disposable income can amplify the ‘blow’ that private consumption is already suffering in the midst of a crisis. On the other hand, another finding of these experts is that it can also lead to an increase in economic inequality, in this case, in expansionary periods of the cycle.

“We have found that this greater progressivity has effects on the distribution of income. With an increase in progressivity, the taxes paid by high-income households are increased and the taxes paid by low-income households are reduced, so one could foresee a fall of inequality. Nothing is further from reality, we find that income inequality grows after applying greater progressivity to the tax system”, the authors of the work maintain.

A surprising result 

At first glance, this result seems contradictory. A reduction in taxes on people with lower salaries or incomes, together with an increase for high incomes, should allow people with lower incomes to achieve a relatively better situation: the disposable income of the poorest and middle strata increases. Which allows them to increase consumption. That is, at least the standard of living of these people should improve. What would most likely happen if the government increased payroll taxes The question or the curious thing is that this improvement does not have to lead to a reduction in inequality.

Therefore, the authors insist: although the above is true, “we see evidence that shows a ‘trickle up’ (income trickles down to the richest households)… Although apparently paradoxical, this result is robust when analyzed inequality, either through the Gini coefficient or with the differentials between the income percentiles at the top (the richest) and the middle of the income distribution”, explain the economists of the San Luis Fed.

How can inequality increase?

So why is income inequality rising? The key lies in what is known as the circular flow of income and in the fiscal multipliers : each expense in the economy is the income of another, when we buy a television we are spending, but the company that sells it (its owners) are entering money.

“When taxes go down, aggregate consumption goes up, which in turn leads to more income for everyone; this, in turn, leads to even higher total consumption…Thus, inequality can increase if people with lower incomes they work for (relatively) fixed wages. While people with higher incomes own much of the capital. They own the shops and capital whose income moves more than wages). When taxes on workers are lowered with lower incomes, consumption increases. In stores owned to a greater extent by people with higher wealth. Despite the fact that people with greater wealth suffer an initial drop. In their disposable income due to the fiscal shock,they see an increase that compensates for this shock thanks to the higher spending of families with medium or low incomes”, explain the authors of the work.

In this way, the owners of the companies see an increase in their income that leads them to consume more. Which in turn increases the income of other agents with significant assets who also own other companies. The result is a multiplier effect that benefits high-income households in several phases or waves. While low-income households only benefit directly once. At the time their taxes are lowered.The net effect is that output increases , but the increase in income may remain, to a large extent, at the top, that is, at high incomes,” say the researchers from the San Luis Fed.

Why is it good for the economy?

Although there is an increase in income inequality, improving the progressivity of the tax system or implementing. A general tax cut has a positive effect on economic growth thanks to the higher marginal. Propensity to consume medium and low-income households. What does this mean? A simple example: a tax cut that affects. For example, Amancio Ortega (increasing his disposable income) will not change his consumption too much. It will probably increase his savings with that extra income because before the tax cut he already had more than plenty of all your needs.

However, a person with a salary of 1,000 euros and who has to deal with many fixed expenses (electricity, rent, car…), would probably take advantage of the increase in their disposable income to increase their consumption and well-being. While greater savings by Amancio Ortega will hardly have any impact on GDP. The greater consumption of the mile vista will directly increase economic production.

Economic Recession

From this, it follows that in the midst of an economic recession. What would most likely happen if the government increased payroll taxes.  A tax cut can have a positive impact on the economy and reduce the damage to activity and employment. Quite the opposite occurs with any type of tax increase, whose effect on GDP and employment will be the opposite.

The economists of the St. Louis Fed explain, in this way, that “an increase in the progressiveness of taxes is expansionary for the economy. This result is something novel: we hypothesize that a reduction in taxes on workers in lower incomes results. In increase consumption and higher production, because these workers tend to be somewhat economically disadvantage. And have a higher marginal propensity to consume than high-income workers. Meanwhile, an increase in taxes on higher-income workers it has a smaller effect on real consumption. And, therefore, does not eliminate the increase in economic activity generated by the reduction of taxes on lower-income workers,” these experts state.


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