Measuring Economic Efficiency Using Inverse-Optimum Weights

This paper provides a method to measure the traditional Kaldor-Hicks notion of “economic efficiency” when taxes affect behavior. In contrast to traditional unweighted surplus, measuring efficiency requires weighting individual benefits (or surplus) by the marginal cost to the government of providing a $1 transfer at each income level. These weights correspond to the solution to the “inverse-optimum” program in optimal tax: they are the social planning weights that would rationalize the status quo tax schedule as optimal. I estimate the weights using the universe of US income tax returns from 2012. The results suggest that measuring economic efficiency requires weighting surplus accruing to the poor roughly 1.5-2 times more than surplus accruing to the rich. This is because $1 of surplus to the poor can be turned into roughly $1.5-$2 of surplus to the rich by reducing the progressivity of the tax schedule. Following Kaldor and Hicks’ original applications, I compare income distributions over time in the US and across countries. The results suggest US economic growth is 15-20% lower due to increased inequality than is suggested by changes in GDP. Because of its higher inequality, the U.S. is unable to replicate the income distribution of countries like Austria and the Netherlands, despite having higher national income per capita.