Optimal Inequality Behind the Veil of Ignorance

Che-Yuan Liang

doi:10.2139/ssrn.2427670

Abstract

In Rawls’ (1971) influential social contract approach to distributive justice, the fair income distribution is the one that an individual would choose behind a veil of ignorance. Harsanyi (1953, 1955, 1975) treats this situation as a decision under risk and arrives at utilitarianism using expected utility theory. This paper investigates the implications of applying prospect theory instead, which better describes behavior under risk. I find that the specific type of inequality in bottom-heavy right-skewed income distributions, which includes the log-normal income distribution, could be socially desirable. The optimal inequality result contrasts the implications of other social welfare criteria.

Highlights

IntroductionHow to distribute income fairly is a question that has been discussed across different disciplines of social science and philosophy. Harsanyi (1953, 1955, 1975) and Rawls
How to distribute income fairly is a question that has been discussed across different disciplines of social science and philosophy. Harsanyi (1953, 1955, 1975) and RawlsI thank Spencer Bastani, Mikael Elinder, Per Engström, Eskil Forsell, Matti Tuomala, and seminar participants at the 2013 Uppsala Center for Fiscal Studies Workshop and the 2013 Nordic Workshop on Tax Policy and Public Economics in Helsinki for valuable comments and suggestions
Harsanyi (1953, 1955, 1975) and Rawls (1971) offered two of the most influential theories of distributive justice. Both used the popular social contract approach starting from an original position where the impartial observer does not know her identity in the society

Summary

Introduction

How to distribute income fairly is a question that has been discussed across different disciplines of social science and philosophy. Harsanyi (1953, 1955, 1975) and Rawls. The evaluation of optimal inequality depends on whether we should give any weight to (dis)satisfaction derived from social comparisons between individuals in a society It depends on whether the type of procedural justice in the original position appropriately embodies impartiality and whether impartiality has intrinsic value. Choice patterns for lottery distributions have been extensively studied theoretically and empirically before It is, possible to apply a calibrated model of decision under risk that relies on the insights of this literature to investigate the problem without the need to ask individuals about their hypothetical preferences in the original position. For a prospect theory impartial observer, the utility function depends on the reference income x0 It is concave for gains (u (x > x0) < 0) and convex for losses (u (x < x0) > 0). Note that for an expected utility impartial observer, the reference income does not affect the social welfare evaluation

Income distributions

Analytical results

Numerical results

Findings

Concluding discussion