The Optimal Linear Income Tax Model: Utility or Equivalent Income?

This paper compares the use of equivalent income with that of utility, in the social welfare function, in optimal income tax models. Equivalent income is a money metric welfare measure that, unlike utility, is not affected by monotonic transformations of utility. The use of equivalent income is found to produce an optimal tax rate that is more sensitive to the degree of inequality aversion, compared with the use of utility. With Cobb-Douglas and CES utility functions, the optimal tax rate is the same for utility and equivalent income where relative inequality aversion is unity. When using equivalent incomes, the case for high marginal rates does not depend on the assumption of a very low elasticity of substitution between consumption and leisure.     

Income Mobility, Inequality and Social Welfare

It is often argued that an observation of rising annual income inequality need not have negative normative implications. The argument is that if there has been a sufficiently large simultaneous increase in mobility, the inequality of income measured over a longer time period can be lower despite the rise in annual inequality. In this paper, it is shown by example that if normative implications are drawn from a standard social welfare function, the set of circumstances put forward in the above argument are not sufficient to guarantee that social welfare will improve. The reason is that even though rising mobility does reduce longer term inequality, it also increases the variability of income profiles over time and the latter has a detrimental social welfare effect. Hence, there are two types of mobility: one which reduces inequality (regression to the mean), but another that increases inequality (relative movements uncorrelated with incomes). Further, if individuals' aversion to income variabiltiy is sufficiently larger than the social welfare judge's aversion to inequality, then an increase in mobility, no matter how large, cannot offset the negative normative effect of rising annual inequality.     

DEPRIVATION,INEQUALITY AND WELFARE*

Welfare ranking of income distributions involves a trade‐off between equity and efficiency. A person's feeling of deprivation about higher incomes may be of a relative or absolute type. We consider an intermediate notion of deprivation, a convex mix of relative and absolute deprivations. We then look at the problem of welfare ranking of income distributions when welfare increases under a globally equitable redistribution and under an income increase that keeps intermediate deprivation fixed. All deprivation indices can be regarded as inequality indices but the converse is not true. We also provide a numerical illustration of our results.     

Multidimensional Inequality Across Three Developed Countries

This paper produces comparable estimates of multidimensional inequality for the U.S., Germany, and Australia. Two alternative approaches with differing interpretations are employed. The first method projects all facets of welfare onto a single variable which is then analyzed using standard univariate techniques. The second approach establishes equivalent‐income distributions that would lead to an equalization of welfare, such that the difference between this counterfactual and the true income distribution can be measured. This difference is then interpreted as the degree of income redistribution required to offset welfare inequality. Using data on permanent incomes, health scores, years of education, and leisure times, we observe much higher levels of inequality in the U.S. than in Germany or Australia. Our results are highly statistically significant and hold over a large variety of weighting specifications.     

CAN HOUSEHOLDS AND WELFARE STATES MITIGATE RISING EARNINGS INSTABILITY?

We compare the evolution of earnings instability in Germany and the United Kingdom, two countries which stand for different types of welfare states. Deploying data from the German Socio‐Economic Panel (SOEP) and the British Household Panel Survey (BHPS), we estimate permanent and transitory variances of male income over the period 1984–2009 and 1991–2006, respectively. Studies in this literature generally use individual labor earnings. To uncover the role of welfare state and households in smoothening earnings shocks, we compute different income concepts ranging from gross earnings to net equivalent household income. We find evidence that the overall inequality of earnings in Germany and the United Kingdom has been rising throughout the period due to both higher permanent earnings inequality and higher earnings volatility. However, taking institutions of the welfare state and risk‐sharing households into account, we find that the volatility of net household income has remained fairly stable. Furthermore, redistribution and risk insurance provided by the welfare state is more pronounced in Germany than in the United Kingdom.     

HOW DO EUROPEANS EVALUATE INCOME DISTRIBUTIONS? AN ASSESSMENT BASED ON HAPPINESS SURVEYS

The purpose of this paper is to measure the evaluation of income inequality by European citizens. Starting from the concept of a social welfare function defined on income distributions the paper estimates the degree and nature of inequality aversion of Europeans. It uses subjective well-being (SWB) as an empirical measure of welfare and estimates how SWB is related to average income and measures of income inequality (from an appropriate class). The estimated relationship is used to determine those inequality measures which qualify as proper representations of people's inequality aversion.     

Redistributive effects of minimal equal sacrifice taxation

We examine the circumstances under which minimal equal sacrifice taxation reduces income inequality. Focusing on absolute sacrifice and relative inequality, we show that after tax incomes are more equally distributed than before tax incomes and that after tax inequality decreases with the revenue to be raised if and only if the elasticity of the marginal utility of income is decreasing. However, other things equal, after tax inequality is shown to decline as the utility function becomes more concave. We investigate next how these conclusions extend when one takes the absolute inequality view and considers that it is the relative loss in utility that has to be equalized across individuals.     

DOES SIZE MATTER? THE IMPACT OF CHANGES IN HOUSEHOLD STRUCTURE ON INCOME DISTRIBUTION IN GERMANY

Income inequality in Germany has been continually increasing during the past 20 years. One cause of this development, among others, could be structural shifts in household formation due to long‐term societal trends. These affect per capita incomes, which has repercussions for the income distribution even if wages remain constant. The aim of this paper is to quantify the proportion of changing household structures in the increase in inequality. We find that the growth of the income gap in Germany (for both East and West from 1991 to 2007) is indeed strongly related to changes in household structure and employment behavior, and a large part of this increase is compensated by the welfare state.     

Income mobility of individuals in China and the United States

Although much has been written about annual income inequality in China, little research has been conducted on longer‐run measures of income inequality and on income mobility. This paper compares income mobility of urban individuals in China and the United States in the 1990s. The following questions are taken up: To what extent are measures of annual income inequality misleading indicators of long‐run income inequality? How much income mobility was there in China in the first half of the 1990s and how did this compare with mobility in other countries? Have real income increases been greater for the poor or the rich? How important is the variation in permanent incomes in China and how has this changed?     

Managerial capital,occupational choice and inequality in a global economy

This study proposes a simple theory of trade with endogenous firm productivity, occupational choice and income inequality. Individuals with different managerial talent choose to become entrepreneurs or workers. Entrepreneurs enhance firm productivity by investing in managerial capital. The model generates three income classes: low‐income workers facing the prospect of unemployment, middle‐income entrepreneurs managing domestic firms and high‐income entrepreneurs managing global firms. Trade liberalization policies raise unemployment and improve welfare. A reduction in per‐unit trade costs raises top incomes and generates labour‐market polarization. A reduction in fixed exporting costs has an ambiguous effect on top incomes and personal income distribution. Policies reducing labour‐market frictions or the costs of managerial‐capital acquisition create more jobs and improve welfare. The income distributional effects of labour‐market policies depend on which policy is implemented.     

Optimum taxation with errors in administration

The paper compares the welfare levels which can be achieved by two distinct tax regimes: lump-sum taxation, where one attempts to identify individuals and allocate transfers or subsidies on the basis of characteristics, and income taxation, where characteristics are not observed but personal incomes are measured and taxed. Where there are no errors in classifying individuals, lump-sum taxation is superior, but, where mistakes are made in the allocation of lump-sum grants or subsidies, income taxation may be more attractive. The level of errors where the regimes are equally desirable in terms of social welfare is computed in simple models following that of Feldstein (1973). Where there is strong aversion to inequality, then income taxation becomes preferable at quite small errors.In analysing income taxation it is shown that in the Feldstein model with endogenous wages the marginal tax rate (in optimum income taxation) on the more skilled is negative and that on the less skilled is positive in contrast to the standard results [see Seade (1977)] with exogenous wages.     

A TREATMENT OF ABSOLUTE INDICES OF POLARIZATION*

Absolute polarization indices remain unchanged under equal absolute augmentation in all incomes. This paper identifies the class of absolute polarization indices whose orderings of alternative income distributions agree with the rankings generated by nonintersecting absolute polarization curves. We explore the possibility of using the Kolm (1976) – Blackorby‐Donaldson (1980) ethical absolute inequality index in polarization measurement. We establish that although inequality and polarization are dissimilar concepts, different absolute inequality indices can be employed to design alternative absolute polarization indices. A numerical illustration is provided using Indian data and it is shown that inequality and polarization are different issues in income distribution analysis.     

A concern about low relative income, and the alignment of utilitarianism with egalitarianism

A utilitarian social planner who maximizes social welfare assigns the available income to those who are most efficient in converting income into utility. However, when individuals are concerned about their income falling behind the incomes of others, the optimal income distribution under utilitarianism is equality of incomes.     

ON THE ROLE OF CAPITAL GAINS IN SWEDISH INCOME INEQUALITY

Realized capital gains are typically disregarded in the study of income inequality. We show that in the case of Sweden this severely underestimates the actual increase in inequality and, in particular, top income shares during recent decades. Using micro panel data to average incomes over longer periods and re‐rank individuals according to income excluding capital gains, we show that capital gains indeed are a reoccurring addition to rather than a transitory component in top incomes. Doing the same for lower income groups, however, makes virtually no difference. We also try to find the roots of the recent surge in capital gains‐driven inequality in Sweden since the 1980s. While there are no evident changes in terms of who earns these gains (high wage earners vs. top capital income earners), the primary driver instead seems to be the drastic asset price increases on the post‐1980 deregulated financial markets.     

Growth,mobility and social progress

We evaluate social progress on the basis of panel data on individual incomes by comparing the value of social welfare in the observed panel data to its value in a situation where individuals receive their first period income in each period. We derive necessary conditions for the welfare gain to be positive, and show how it can be decomposed in an effect of economic growth, a mobility effect and a cost due to aversion to time fluctuations given individuals’ ranks in the income distribution. The mobility effect, generated by reranking in the income distribution has two components: a cost due to time fluctuations in incomes and a benefit, due to equalization in time averaged incomes. We illustrate the analysis using CNEF data for Australia, Korea, Germany, Russia, Switzerland and the US. Our results indicate that the largest component of social progress is the equalization of time averaged income, induced by reranking. In countries with high growth (Australia, Korea and Russia), the growth effect is larger than the mobility effect, but in countries with low growth (Germany, Switzerland and the US), the opposite holds true. The poor performance of the US is explained by the large costs of income fluctuations and the way economic growth is distributed.     

Household Income Inequality and Income Mobility: Implications Towards Equalizing Longer-Term Incomes in India

This paper addresses three important questions. First, what are the trends, levels and sources of income inequality in India? Second, how have been the patterns of income mobility? And finally, exploring the relationship between income mobility and income inequality in the context of India. Results, based on recent India Human Development Survey (IHDS) longitudinal data, advocate that not only is income inequality very high, nonetheless, it has increased – mainly attributable to different income sources – in India. The paper also focused on whether or not this income mobility equalizes longer-term incomes. Results suggest income mobility has resulted in-albeit not robust- equalizing longer-term incomes. Thus, based on imperative findings, the paper suggests, the nature of longer-term well-being is crucial to designing policy interventions to effectively tackle inequality and in this context, economic mobility can be seen as an avenue to long-term equality.     

Income comparison and happiness: The role of fair income distribution

Relative income gap is one of the most popular approaches for explaining the income–happiness relationship. We argue in this article that when people compare their incomes, they care about distributional fairness more than relative income disparity. It is difficult for us to explain China's income–happiness paradox if we simply compare the income gap and do not explore the income‐generation process leading to income inequality. We therefore employ an approach based on a responsibility‐sensitive theory of justice that decomposes individual income into fair and unfair components. As a proxy for distributional unfairness, unfair income is considered the main source of unhappiness. Using data from the Chinese Household Income Project survey, we find strong support for the negative relationship between income unfairness and happiness. We also find a significantly positive relationship between the relative income gap and income unfairness, which leads us to consider the income comparison hypothesis as the explanation for the income–happiness paradox in a new light. Sensitivity analyses confirm the robustness of our results.     

Taxation and Tournaments

This paper analyzes the effects of progressive taxes on labor supply and income distribution in the context of the rank‐order tournament model originally developed by Lazear and Rosen (1981). We show conditions under which a more progressive tax schedule will cause so large general equilibrium effects that the inequality in disposable income will actually increase. We also show that a non‐zero redistributive tax is always optimal if society's welfare function displays inequality aversion; this result always holds, regardless of behavioral responses and general equilibrium effects.     

Income Mobility and Income Inequality in Rural China

The economic literature has argued for a long time that income mobility could attenuate the degree of cross-sectional inequality by offering people opportunities to improve their socio-economic position. Using the longitudinal data from the China Health and Nutrition Survey (CHNS) from 1989 to 2011, we measure income mobility as the degree to which longer-term incomes are distributed more or less equally than yearly income. Five main results are emphasized. First, there is strong income mobility in rural China that partly offsets yearly income inequality. Second, income mobility has decreased since the 2000s, indicating that income distribution is becoming more rigid. Third, mobility is mainly associated with transitory income fluctuations, particularly in the two tails of the distribution. Fourth, income mobility has an equalizing effect on income distribution. Fifth, we show that non-agricultural income mobility has substantially increased over the period and that its equalizing nature has also recently increased. While the development of the non-agriculture sector in rural China was a crucial factor in explaining the increase in rural inequality until the mid-2000s, we suggest that the large-scale generalisation of such non-agricultural opportunities partly accounts for the decline in rural inequality observed since the mid-2000s.     

Understanding Rising Income Inequality in Germany, 1999/2000–2005/2006

We examine the factors behind rising income inequality in Europe's most populous economy. From 1999/2000 to 2005/2006, Germany experienced an unprecedented rise in net equivalized income inequality and poverty. At the same time, unemployment rose to record levels, part‐time and marginal part‐time work grew, and there was evidence for a widening distribution of labor incomes. Other factors that possibly contributed to the rise in income inequality were changes in the tax and transfer system, changes in the household structure (in particular the rising share of single parent households), and changes in other socio‐economic characteristics (e.g., age or education). We address the question of which factors were the main drivers of the observed inequality increase. Our results suggest that the largest part of the increase was due to increasing inequality in labor incomes, but that changes in employment outcomes and changes in the tax system also contributed considerable shares. By contrast, changes in household structures and household characteristics, as well as changes in the transfer system only seem to have played a minor role.