This paper studies the distributional consequences of a systematic variation in expenditure shares and prices. Using European Union Household Budget Surveys and Harmonized Index of Consumer Prices data, we construct household-specific price indices and reveal the existence of a pro-rich inflation in Europe. Over the period 2001–15, the consumption bundles of the poorest deciles in 25 European countries have, on average, become 11.2 percentage points more expensive than those of the richest deciles. We find that ignoring the differential inflation across the distribution underestimates the change in the Gini (based on consumption expenditure) by almost up to 0.04 points. Cross-country heterogeneity in this change is large enough to alter the inequality ranking of numerous countries. The average inflation effect we detect is almost as large as the change in the standard Gini measure over the period of interest.

The development of inequality has received increasing attention in recent years. While inequality of disposable income has significantly increased in some countries, it was rather stable in other European countries. One possible weakness of existing studies that try to document the development of inequality is the use of a uniform consumer price inflation rate (CPI). Using such a common CPI implicitly assumes that the consumption baskets of low income households are subject to the same price increase as the consumption baskets of more affluent households. However, if price increases are more prevalent for goods that are disproportionally consumed by poorer households, then the standard approach of studying inequality measures over time will underestimate the change in inequality. Against this background, the present paper studies the distributional consequences of a systematic variation in expenditure shares and prices. Using European Union Household Budget Surveys and Harmonized Index of Consumer Prices data, we construct householdspecific price indices and ask whether inflation in recent years was lower for households belonging to upper deciles. Within a sample of 25 EU countries over the period 2001-15, our calculations reveal the existence of a pro-rich inflation. This means that, compared to consumption baskets consumed by lower deciles, the consumption baskets of the more affluent deciles had a lower inflation rate. This holds for almost all countries. Across countries, the consumption bundles of the poorest deciles have, on average, become 10.5 percentage points more expensive than those of the richest decile. This translates in a yearly inflation difference of 0.72 percentage points and is a considerable difference if compared to the average CPI of 2.67%. We find that ignoring the differential inflation across the distribution underestimates the change in the Gini measure (based on consumption expenditure) by up to 0.03 points. The inflation effect is not uniform across countries. Therefore, the crosscountry heterogeneity of pro-rich inflation is large enough to alter the inequality ranking of numerous countries. The average inflation effect we detect is almost as large as the change in the standard Gini measure over the period of interest. For many countries, the usual inequality measures do not indicate a pronounced change. Our results may help explaining the general concern among Europeans about increasing inequality that nevertheless seems to exist. Our study raises the question of how governments should react with their income redistribution to different inflation rates for differently affluent households.

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This study simulates three income tax scenarios in a Mirrleesian setting for 24 EU countries using data from the 2014 Structure of Earnings Survey. In scenario 1, each country individually maximizes its own welfare (benchmark). In scenarios 2 and 3, total welfare in the EU is maximized over a common budget constraint. Unlike scenario 2, the social planner of scenario 3 differentiates taxes by country of residence. If a common tax and transfer system were implemented in the EU, countries with a relatively higher mean wage rate—particularly those in Western and some of the Northern European countries—would transfer resources to the others. Scenario 2 implies increased labor distortions for almost all countries and, hence, leads to a contraction in total output. Scenario 3 produces higher (lower) marginal taxes for high- (low-) mean countries compared to the benchmark. The change in total output depends on the income effects on labor supply. Overall, total welfare is higher for the scenarios involving a European tax and transfer system despite more than two thirds of all the agents becoming worse off relative to the benchmark. A politically more feasible integrated tax system improves the well-being of almost half of all the EU but considerably reduces the aggregate welfare benefits.

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