Optimal tax
Encyclopedia
Optimal tax theory is the study of how best to design a tax
to minimize distortion
and inefficiency subject to increasing set revenues through distortionary taxation. A neutral tax is a theoretical tax which avoids distortion and inefficiency completely.. Other things being equal, if a tax-payer must choose between two mutually exclusive economic projects (say investments) that have the same pre-tax risk and returns, the one with the lower tax or with a tax exemption would be chosen by a rational
actor. Thus economists argue that taxes generally distort behavior.
For example, since only economic actors who engage in market activity of "entering the labor market" have an income tax liability on their wages, people who are able to consume leisure or engage in household production outside the market by say providing housewife services in lieu of hiring a maid are taxed more lightly. With the "married filing jointly" tax unit in U.S. income tax law, the second earner's income is added to the first wage earner's taxable income and thus gets the highest marginal rate. This type of tax creates a large distortion disfavoring women from the labor force during years when the couple have great child care needs.
The incidence of sales tax
es on commodities also results in distortion if say food prepared in restaurants is taxed but supermarket-bought food prepared at home is not taxed at purchase. If a taxpayer needs to buy food at fast food restaurants because he/she is not wealthy enough to purchase extra leisure time (by working less) he/she pays the tax although a more prosperous person who enjoys playing at being a home chef is taxed more lightly. This differential taxation of commodities may cause inefficiency (by discouraging work in the market in favor of work in the household).
Ramsey
(1927) developed a theory for optimal commodity sales taxes. The intersection on downward sloping demand curve
and upward sloping supply curves implies that there is producer surplus and consumer surplus. Any sales tax reduces output and imposes a deadweight loss
(DWL). If we assume nonvarying demand and supply elasticities, then a single uniform rate of tax on all commodities would seem to minimize the sum area of all such DWL triangles. Ramsey proposed that we assume suppliers were all perfectly elastic in their responses to price changes from tax and then concluded that taxes on goods with more inelastic consumer demand response would have smaller DWL distortions. Thus, we would tax MILK more than PAPAYA JUICE if consumers were more inelastic in their demand for cow’s milk. The DWL triangles are now termed Harberger triangles
(for Arnold Harberger
).
Modern theory of optimal taxation can be used to evaluate the efficiency of tax reforms in regard to marginal deadweight losses (Mayshar 1990, Slemrod & Yitzhaki 1996).
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
to minimize distortion
Distortions (economics)
A distortion is a condition that creates economic inefficiency, thus interfering with economic agents maximizing "social welfare" when they maximize their own welfare....
and inefficiency subject to increasing set revenues through distortionary taxation. A neutral tax is a theoretical tax which avoids distortion and inefficiency completely.. Other things being equal, if a tax-payer must choose between two mutually exclusive economic projects (say investments) that have the same pre-tax risk and returns, the one with the lower tax or with a tax exemption would be chosen by a rational
Rationality
In philosophy, rationality is the exercise of reason. It is the manner in which people derive conclusions when considering things deliberately. It also refers to the conformity of one's beliefs with one's reasons for belief, or with one's actions with one's reasons for action...
actor. Thus economists argue that taxes generally distort behavior.
For example, since only economic actors who engage in market activity of "entering the labor market" have an income tax liability on their wages, people who are able to consume leisure or engage in household production outside the market by say providing housewife services in lieu of hiring a maid are taxed more lightly. With the "married filing jointly" tax unit in U.S. income tax law, the second earner's income is added to the first wage earner's taxable income and thus gets the highest marginal rate. This type of tax creates a large distortion disfavoring women from the labor force during years when the couple have great child care needs.
The incidence of sales tax
Sales tax
A sales tax is a tax, usually paid by the consumer at the point of purchase, itemized separately from the base price, for certain goods and services. The tax amount is usually calculated by applying a percentage rate to the taxable price of a sale....
es on commodities also results in distortion if say food prepared in restaurants is taxed but supermarket-bought food prepared at home is not taxed at purchase. If a taxpayer needs to buy food at fast food restaurants because he/she is not wealthy enough to purchase extra leisure time (by working less) he/she pays the tax although a more prosperous person who enjoys playing at being a home chef is taxed more lightly. This differential taxation of commodities may cause inefficiency (by discouraging work in the market in favor of work in the household).
Ramsey
Frank P. Ramsey
Frank Plumpton Ramsey was a British mathematician who, in addition to mathematics, made significant and precocious contributions in philosophy and economics before his death at the age of 26...
(1927) developed a theory for optimal commodity sales taxes. The intersection on downward sloping demand curve
Demand curve
In economics, the demand curve is the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule...
and upward sloping supply curves implies that there is producer surplus and consumer surplus. Any sales tax reduces output and imposes a deadweight loss
Deadweight loss
In economics, a deadweight loss is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal...
(DWL). If we assume nonvarying demand and supply elasticities, then a single uniform rate of tax on all commodities would seem to minimize the sum area of all such DWL triangles. Ramsey proposed that we assume suppliers were all perfectly elastic in their responses to price changes from tax and then concluded that taxes on goods with more inelastic consumer demand response would have smaller DWL distortions. Thus, we would tax MILK more than PAPAYA JUICE if consumers were more inelastic in their demand for cow’s milk. The DWL triangles are now termed Harberger triangles
Harberger's Triangle
Harberger's triangle, generally attributed to Arnold Harberger, refers to the dead weight loss associated with government intervention in a perfect market...
(for Arnold Harberger
Arnold Harberger
Arnold C. Harberger is a United States economist. Harberger's Triangle, widely used in welfare economics, is named after him.-Life:...
).
Modern theory of optimal taxation can be used to evaluate the efficiency of tax reforms in regard to marginal deadweight losses (Mayshar 1990, Slemrod & Yitzhaki 1996).
See also
- Tax per head
- Excess burden of taxationExcess burden of taxationIn economics, the excess burden of taxation, also known as the distortionary cost or deadweight loss of taxation, is one of the economic losses that society suffers as the result of a tax. Economic theory posits that distortions changes the amount and type of economic behavior from that which...
- Lump-sum taxLump-sum taxA lump-sum tax is a tax that is a fixed amount, no matter the change in circumstance of the taxed entity....
- Non-profit organizationNon-profit organizationNonprofit organization is neither a legal nor technical definition but generally refers to an organization that uses surplus revenues to achieve its goals, rather than distributing them as profit or dividends...
- Tax avoidance and tax evasionTax avoidance and tax evasionTax noncompliance describes a range of activities that are unfavorable to a state's tax system. These include tax avoidance, which refers to reducing taxes by legal means, and tax evasion which refers to the criminal non-payment of tax liabilities....
- Tax fraud
- Tax policyTax policyTax policy is the government's approach to taxation, both from the practical and normative side of the question.-Philosophy:Policymakers debate the nature of the tax structure they plan to implement and how they might affect individuals and businesses .The reason for such foitution effect]],...
- Tax resistanceTax resistanceTax resistance is the refusal to pay tax because of opposition to the government that is imposing the tax or to government policy.Tax resistance is a form of civil disobedience and direct action...
- Tax shelterTax shelterTax shelters are any method of reducing taxable income resulting in a reduction of the payments to tax collecting entities, including state and federal governments...
- Wealth taxWealth taxA wealth tax is generally conceived of as a levy based on the aggregate value of all household holdings actually accumulated as purchasing power stock , including owner-occupied housing; cash, bank deposits, money funds, and savings in insurance and pension plans; investment in real estate and...
- Fair Tax