From Nathan Hendren:
This paper develops a method for resolving the equity-efficiency tradeoff that modifies the Kaldor-Hicks compensation principle to account for the distortionary cost of redistribution. The inequality deflator weights surplus by the marginal cost of providing transfers to a point of the income distribution using modifications to 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. This is not because of a subjective preference for the poor per se, but rather because their surplus 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 then study several applications. First, I show the inequality deflator weights producer surplus at 77% relative to consumer surplus. Second, I show the social cost of rising inequality since 1970 is roughly $5,250 per household. Third, I provide a new ordering of country incomes per capita. For example, inequality deflated income in the U.S. is lower relative to Austria and the Netherlands, despite having higher national income per capita. I conclude by providing a modified Samuelson condition that characterizes the existence of potential Pareto improvements from local government policy changes.