The Inequality Deflator: Interpersonal Comparisons without a Social Welfare Function

This paper develops a tractable method for resolving the equity-efficiency tradeoff that modifies the Kaldor-Hicks compensation principle to account for the distortionary cost of redistribution. Weighting measures of individual surplus by the inequality deflator corresponds to searching for local Pareto improvements by making transfers through the income tax schedule. Empirical evidence consistently suggests redistribution from rich to poor is more costly than redistribution from poor to rich. As a result, the inequality deflator weights surplus accruing to the poor more so than to the rich. Regardless of one's own social preferences, surplus to the poor can hypothetically be turned into more surplus to everyone through reductions in distortionary taxation. I estimate the deflator using existing estimates of the response to taxation, combined with a new estimation of the joint distribution of taxable income and marginal tax rates. I show adjusting for increased income inequality lowers the rate of U.S. economic growth since 1980 by roughly 15-20%, implying a social cost of increased income inequality in the U.S. of roughly $400 billion. Adjusting for differences in income inequality across countries, the U.S. is poorer than countries like Austria and the Netherlands, despite having higher national income per capita. I conclude by providing an empirical framework for characterizing the existence of local Pareto improvements from government policy changes.