Decomposition of progressivity and inequality indices: Inferences from the US federal income tax system

Vertical equity is an important criterion in evaluating a tax system. Vertical equity has two elements: progressivity and income equality. In this paper, we analyze the vertical equity effects of the US income tax system during 1995-2006 and show that income inequality increased substantially during the period combined with a significant reduction in real progressivity.Using a Lorenz-curve-based graphical method, we decompose progressivity and income inequality indices and identify and quantify how much each source of income contributes to overall progressivity and income inequality. Results for the 1995-2006 period indicate that US income tax treatment of Salaries and Wages income were distributed and taxed progressively and contributed to a decrease in income inequality. However, the treatment of Net Capital Gains not only decreased progressivity, it negated the income inequality reduction achieved by salaries and wages.These results show that to evaluate the vertical equity of a tax system, both income inequality and progressivity indexes must be considered. Additionally, the decomposition method allows policy makers to estimate the progressivity and income inequality effects of marginal changes in income source and how each source is taxed.