How does globalisation drive inequality and the optimal tax rate?

Research from Warwick Economics and the University of Munich has offered a new explanation for why tax systems have failed to address rising levels of inequality in many modern economies.

Empirical studies have shown that globalisation has raised wage inequality and the concentration of earnings at the top of the income distribution. Rather than tax levels increasing when top incomes rise, however, this is often accompanied by a fall in the optimal rate of redistributive taxation, meaning that tax systems fail to effectively share wealth across society.

Professor Carlo Perroni and colleagues argue that increased integration of markets and the prevalence of performance-based contracts help to explain why this is the case.

They observe that globalisation has led to greater integration of product markets, increasing competition and making it harder for any single firm to make a positive profit but allowing those that are successful to reap higher rewards. This feeds into labour markets and the prevalence of incentive contracts, where workers are awarded bonuses or other performance-based benefits: globalisation makes product markets potentially more profitable but also more competitive, translating into steeper incentive contracts and greater volatility of individual earnings.

The researchers’ analysis, based on US income data, reveals that while globalisation increases the income share of workers in successful firms, it reduces the effectiveness of income tax as a tool for redistributing wealth as redistributive taxation is unable to counter the higher income inequality that arises from steeper incentive contracts. At the same time, performance-based pay leads to a lower optimal tax rate, as workers are dis-incentivised from performing if tax levels are too high and more likely to opt for the security of fixed-salary contracts.

The researchers argue that a similar increase in income concentration in an economy with fixed contracts would lead to a higher optimal tax rate.

Find out more

‘Incentives, Globalisation and Redistribution’, by Carlo Perroni, Antoine Ferey and Andreas Haufler, is forthcoming in the Journal of Public Economics.

Carlo Perroni is Professor of Economics at Warwick. View his staff profile.