Efficiency, Insurance, and Redistribution Effects of Government Policies

This paper decomposes welfare measures of policy reforms into parts attributable to redistribution and parts due to efficiency. We further decompose efficiency into subcomponents such as gains from better insurance against idiosyncratic and aggregate risk. Our decomposition of welfare measures associated with alternative feasible allocations is cast in terms of a coordinate system that uses generalized Pareto–Negishi weights to capture inequality and production and consumption wedges to capture distortions. Our decomposition has several desirable properties. It attributes welfare changes from movements along a Pareto frontier to redistribution; it attributes negative efficiency changes to movements away from the Pareto frontier; and it produces subcomponent shares of welfare changes that are numeraire-invariant and symmetric with respect to the direction of the reform. Our decomposition can be explained in terms of an implicit tax-and-transfer system in which redistribution captures real income changes, efficiency captures deadweight losses, and output costs.