Unveiling the impact of income taxes on inequality in a HACT model

Abstract

I introduce a tax shock into a “standard” heterogeneous agent model in continuous time (HACT) to quantify the effect of an income tax on inequality. I find that an income tax, collecting 15% of output, reduces the Gini coefficient by up to 16.9% in an economy with a perfect credit market and up to 24.3% in financial autarky. The tax has a modest effect on production labor income inequality, reduces inequality in entrepreneurial income under financial autarky, but raises it when entrepreneurs operate in a perfect credit market. I also explore the effect of the tax on other well-known income inequality measures discussed in the literature.