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Inequality as an externality: consequences for tax design

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  • Støstad, Morten Nyborg
  • Cowell, Frank

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.

Suggested Citation

  • Støstad, Morten Nyborg & Cowell, Frank, 2024. "Inequality as an externality: consequences for tax design," LSE Research Online Documents on Economics 123752, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:123752
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    2. Brian Hill, 2023. "Being up Front about Income Inequality," Working Papers hal-02896664, HAL.
    3. Max Lobeck & Morten Nyborg Støstad, 2023. "The Consequences of Inequality: Beliefs and Redistributive Preferences," Working Papers halshs-04423608, HAL.
    4. Xun Lu & Xinyue Ke & Yixuan Ma & Mingdong Jiang, 2025. "Towards More Water-Efficient Agriculture: A Study on the Impact of China’s Water Resource Tax on Agricultural Water Use Efficiency," Sustainability, MDPI, vol. 17(5), pages 1-18, March.
    5. Lobeck, Max & Morten.Stostad@nhh.no, Morten Nyborg, 2023. "The Consequences of Inequality: Beliefs and Redistributive Preferences," Discussion Paper Series in Economics 17/2023, Norwegian School of Economics, Department of Economics.

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    Keywords

    externalities; inequality; optimal income taxation; welfare;
    All these keywords.

    JEL classification:

    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H23 - Public Economics - - Taxation, Subsidies, and Revenue - - - Externalities; Redistributive Effects; Environmental Taxes and Subsidies
    • D62 - Microeconomics - - Welfare Economics - - - Externalities

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