Using a standard incomplete-markets model, we compute the welfare of two socioeconomic systems: laissez-faire and egalitarianism. The egalitarian system (in which after-tax wages are compressed) provides insurance against income risks but at the cost of inefficiency: it undermines productive workers' incentives to work. When the stochastic process of idiosyncratic productivity shocks are calibrated to match the earnings inequality, the egalitarian society yields a much higher welfare as the insurance benefit dominates the efficiency loss. However, when the idiosyncratic productivity shocks are calibrated to capture the ex-post heterogeneity of earnings only, households are better off under laissez-faire if the labor supply is elastic enough. Transition between the two regimes is computed. When the wage compression is removed from the egalitarian steady state, the inequality emerges quickly and reaches its laissez-faire steady state in 20 years.
©2012 Walter de Gruyter GmbH & Co. KG, Berlin/Boston