Inequality, the politics of redistribution and the tax mix

Political economy literature generally predicts a positive relationship between income inequality and redistribution. However, there is no clear empirical evidence supporting such a relationship. By incorporating an informal sector that evades income taxes, we account for the tax-base effect that, along with the political channel, determines the equilibrium redistribution and tax mix. We find a non-monotonic relationship between inequality and redistribution and explore under which conditions an unequal society relies more heavily on indirect taxes to finance redistribution. Ultimately, this paper shows the limitations of the income tax to finance redistribution in developing countries even when taxes are democratically chosen.

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