Understanding changes in the distribution and redistribution of income: A unifying decomposition framework

Over recent decades income inequality has increased in many developed countries. Although the tax and transfer system is the main institutional tool through which income is redistributed, the role it played in these changes is often poorly understood. By building a bridge between existing approaches, we propose a method allowing for the decomposition of historical changes in various income distribution and redistribution measures into (i) the immediate effect of tax-transfer policy reforms in the absence of labour supply responses, (ii) the effect of labour supply changes induced by these reforms, (iii) the impact of changes in the distribution of other determinants, including the effect of employment changes not induced by policy reforms. We illustrate the use of our decomposition method by analysing the case of Australia between 1999 and 2007. We find that the direct effect of tax-transfer policy reforms accounts for about half of the observed increase in income inequality over the period. About one fifth of this direct effect was offset by labour supply responses to these policy reforms. Although ageing, increased educational attainments and changes in income unit structures played a limited role, we find evidence that the increased dispersion of wages and capital incomes substantially increased income inequality.