Labor share as an "automatic stabilizer" of income inequality

Abstract

We provide a new and unexplored explanation of the relationship between the functional and personal distribution of income. By proposing a simple theoretical framework, we show that, in the noncomprehensive personal income tax (PIT) hypothesis (i.e., when some or all capital income items are excluded from the PIT base), the correlation between disposable and market income inequality depends on the labor share level, which may influence the overall effectiveness of the tax-benefit system in addition to the PIT progressivity. We test our hypothesis using panel data on 33 OECD countries from 2000 to 2017 and find that a 10-pp increase in labor share is related to a 0.06 reduction in the correlation between market and disposable income inequality. This significant result obtained after controlling for country and year fixed effects, country-specific linear trends, and several confounders capturing the characteristics of the tax-benefit system suggests that labor share may act as an "automatic stabilizer" of market income inequality. Relevant implications for tax policy concern the role of the PIT's base for the public budget's overall redistributive effect.