Using a Structural Labor Supply Model to Calculate Inverse-Optimal Marginal Social Welfare Weights
We calculate the implied marginal social welfare weights if the current German tax-transfer system is optimal. At the optimum, the cost of providing one Euro to a specific group must equal its weighted benefit. For every percentile of the income distribution, we calculate the cost of transferring 100 Euro to individuals in the percentile. A structural labor supply model allows us to simulate labor supply reactions to small local tax reductions. The advantage of this simulation approach is that we do not need to restrict labor supply in any way to obtain analytical solutions. We find that the tax-transfer system is optimal if the society values one Euro for households at the 10th percentile twice as much as one Euro for households at the median. Weights for people at the 20th percentile are slightly lower than for the middle class. This result is driven by couples with children.