Inequality as an Externality: Consequences for Tax Design

This paper proposes to treat income inequality as an economic externality in order to in troduce the societal effects of inequality into welfarist models. We introduce such effects in a simple and generalizable welfarist framework and show that they can have sizeable optimal policy consequences that cannot be captured by standard risk aversion or social welfare weights. Novel policy implications are illustrated through the classical optimal non-linear income taxation model, where the social planner must face a trade-off between collecting revenue and changing income inequality levels. Resulting policy consequences are disproportionately located at the top, where optimal marginal tax rates are strongly and robustly dependent on the magnitude of the inequality externality. We use several real-world examples to show that tax policy previ ously unsupported by optimal taxation theory can be explained in our framework. The findings indicate that the magnitude of the inequality externality could be considered a crucial economic variable.