DP6710 Evidence on the Insurance Effect of Marginal Income Taxes

Author(s): Charles Grant, Christos Koulovatianos, Alexander Michaelides, Mario Padula
Publication Date: February 2008
Keyword(s): Consumption Insurance, Tax Distortions, Undiversifiable Earnings Risk
JEL(s): E21, H20, H31
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6710

Marginal income taxes may have an insurance effect by decreasing the effective fluctuations of after-tax individual income. By compressing the idiosyncratic component of personal income fluctuations, higher marginal taxes should be negatively correlated with the dispersion of consumption across households, a necessary implication of an insurance effect of taxation. Our study empirically examines this negative correlation, exploiting the ample variation of state taxes across US states. We show that taxes are negatively correlated with the consumption dispersion of the within-state distribution of non-durable consumption and that this correlation is robust.