Income Tax Progressivity and Income Inequality: the Case of Payroll Tax with Evidence from Ethiopia

Abstract

This research is intended to assess the progressivity of payroll tax in respect to employment income inequality. The research is based on only ten years’ data on payroll income. Over time, the primary data were obtained using a systematic random sampling technique from nine different organisations. Qualitative data were analysed with descriptive tools and simple regression analysis, while the comparison between the marginal tax rate and the average tax rate, and the computation of the Suits Index and the Gini coefficients from the Lorenz curves were applied for the quantitative analysis. As a result, we found that the payroll tax was significantly progressive, but eventually declined after the 6th tax bracket. On the other hand, the varying and higher values of the Gini coefficient for different organisations show higher income inequalities before tax. Moreover, in comparison with other nations the tax rate appears less redistributive, reducing the value of the Gini coefficient only slightly. In addition, the prevailing level of inflation was found to reduce the exemption thresholds and the width of the tax brackets, while pushing income to higher brackets. Therefore, the skill gap among employees needs to earn fair payment that would be subjected to tax rate compatible with inflation. Lastly, preferential tax rates should be applied on employment income to ensure fair income distribution among households earning income from different sources and encourage labour intensive industries to ensure social, political and economic stability across the nation.