On the efficiency and equity trade-off

The concept of policy measures that create a potential Pareto improvement has dominated normative economics. The use of this concept in welfare economics relies on the availability of discriminatory lump-sum transfers in such a way that the implementation of the efficient policy measure leads to a Pareto movement in the economy. However, most studies of efficient policies preclude by assumption the existence of lump-sum taxation. This paper proposes, in economies amenable to Gorman aggregation, one simple methodology to rank alternative allocations in terms of their distributional implications, in a world with no lump-sum transfers. This methodology is simple because it is independent of the distribution of characteristics in the economy. Then, for a specific policy measure, it can be easily identified whether it implies an equity-efficiency trade-off. The method is illustrated by analyzing the effects on inequality of the elimination of capital taxation, the reduction of the inflation tax, and the liberalization of capital movements in a small open economy.