Inequality as an externality: consequences for tax design

Støstad, Morten Nyborg and Cowell, Frank (2024) Inequality as an externality: consequences for tax design. Journal of Public Economics, 235. ISSN 0047-2727

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Abstract

Economic inequality may affect a wide range of societal outcomes, for example crime rates, economic growth, and political polarization. In this paper we discuss how to model such effects in welfarist frameworks. Our main suggestion is to treat economic inequality itself as an externality, which has wide-ranging implications for classical economic theory. We show this through the Mirrlees (1971) optimal non-linear income taxation model, where we focus on a post-tax income inequality externality. Optimal top marginal tax rates are particularly affected by the externality, implying a novel equality dimension to optimal top tax rate design. We propose that inequality's externality properties may have larger optimal top tax rate implications than standard revenue concerns; our model thus provides a theoretical basis for real-world governmental tax choices that seem irrational under standard optimal taxation models. We also show that the total inequality aversion implied by the current U.S. tax system is insufficient to accommodate both social welfare weights that are decreasing in income and a significant concern for inequality's externality effects.

Item Type:	Article
Official URL:	https://www.sciencedirect.com/journal/journal-of-p...
Additional Information:	© 2024 The Authors
Divisions:	Economics
Subjects:	H Social Sciences > HJ Public Finance H Social Sciences > HB Economic Theory
JEL classification:	H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H21 - Efficiency; Optimal Taxation H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H23 - Externalities; Redistributive Effects; Environmental Taxes and Subsidies D - Microeconomics > D6 - Welfare Economics > D62 - Externalities
Date Deposited:	04 Jun 2024 11:24
Last Modified:	18 Jun 2024 20:21
URI:	http://eprints.lse.ac.uk/id/eprint/123752

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