Inequality aversion, macroeconomic objectives and the marginal welfare cost of indirect taxation Does flexibility of prices and wages matter?

Abstract

We compare directions of welfare improving marginal tax reform in a situation of involuntary unemployment. We show the role of distributional considerations in assessing these welfare effects: preferences between macroeconomic variables shift with the degree of inequality aversion. To get a better insight into the importance of distributional considerations in different models, we compare the marginal welfare costs of taxation within three different specifications: the Keynesian regime, a flexible prices/fixed wage-model, and a flexible prices/trade union wage-model. These various models are calibrated for Belgian data of 1980. It turns out that the choice of model matters, even in a marginal perspective. The empirical results also show how the welfare costs in the different models vary with the degree of inequality aversion.