Scandinavian Working Papers in Economics

Working Paper Series, Center for Fiscal Studies,
Uppsala University, Department of Economics

No 2013:4: Optimal Inequality behind the Veil of Ignorance

Che-Yuan Liang ()
Additional contact information
Che-Yuan Liang: Uppsala Center for Fiscal Studies, Postal: Department of Economics, Uppsala University, P.O. Box 513, SE-751 20 Uppsala, Sweden

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.

Keywords: veil of ignorance; prospect theory; social welfare function; income inequality

JEL-codes: D03; D31; D63; D81

26 pages, April 29, 2013

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