New publication in German Economic Review  [02.09.24]

The German “Tax-Reform 2000” involved a strong reduction in the progressivity of labor income taxation. It led to a rise in overall labor income, but also increased income inequality. Utilizing data from the German Socio-Economic Panel (SOEP) for the years 1998–2007, Prof. Dr. Benjamin Jung and Dr. Timo Walter employ a general equilibrium framework to quantity the effects of the tax reform on social welfare. Moreover, they compose the change in social welfare into three components: (i) the fundamental social welfare that would arise in a Kaldor-Hicks economy with lump-sum transfers, (ii) a correction term that accounts for the social cost of inequality à la Atkinson or Sen, and (iii) a correction term for the social cost of distortionary taxation. 

Under their baseline calibration, the numerical analysis yields the following results: First, the main driver of growth in social welfare from 1998 to 2007 was fundamental social welfare. Second, the counterfactual analysis shows that the reform resulted in an annual average income growth of 0.62 % and an increase in income inequality of 0.32 %, indicating an only modest increase in social welfare of 0.07 %. Third, the actual tax progression converged to its social welfare maximizing level.

The paper was recently accepted by the German Economic Review and is available ahead of print.

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