The German “Tax-Reform 2000” involved a strong reduction in the progressivity of labor income taxation. It led to a rise in overall labor income, but also increased income inequality. Utilizing data from the SOEP, we employ a general equilibrium framework a la Antras et al. (2017). The model imposes a constant rate of tax progressivity and allows for a theoryconsistent decomposition of social welfare that highlights the equity-efficiency trade-off, namely into (i) the fundamental social welfare level that would arise in a Kaldor-Hicks economy with lump-sum transfers, (ii) a correction terms that accounts for the social cost of inequality a la Atkinson (1970) or Sen (1970), and (iii) a correction term for the social cost of distortionary taxation. Our estimations show that the tax system can be well approximated by the imposed tax schedule and that the reform implied a fall in the degree of tax progressivity. Under the baseline calibration, the numerical analysis yields the following results: First, the main driver of growth in social welfare from 1998 to 2007 was fundamental social welfare. Second, the counterfactual analysis shows that the reform resulted in an annual average income growth of 0.62%.
