# Lecture 4 - 4 Optimal taxation 4.1 Introduction Previously...

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Unformatted text preview: 4 Optimal taxation 4.1 Introduction Previously we analyzed the efficiency and incentive consequences of a single tax. Now we ask: What is a good tax system? What is the best way to trade off inefficiencies of different tax bases? 4.2 Commodity taxation What is the most efficient pattern of excise taxation? Conventional wisdom suggests that uniform taxation of all goods. We will see this is erroneous. As argued in Lecture 3, even a uniform tax system cannot eliminate all relative price distortions. The general problem is to raise revenue with the smallest possible excess burden. Equivalently, we are maximizing utility of the representative consumer, subject to the government budget con- straint. Formally, we solve min t EB ( t ) subject to i R ( t ) G The first-order conditions for this problem are EB ( t ) t i = R ( t ) t i for all i , or EB i / R i = for all i . The left-hand side of this expression is the marginal excess burden per dollar of additional revenue raised from tax base i . The formula says this should be equal for all tax bases. To interpret this, recall our approximate formula for excess burden: EB i 1 2 t i x c i so that EB i x c i /2 . The revenue from this tax is t i x i , so that a small increase in t i causes revenue to rise by approximately x i . The first-order condition then says, approximately, x c i x i = x c j x j for all i , j . This is known as the Ramsey rule . In an efficient tax system, taxes should induce approximately the same percentage reduction in compensated demand for all goods. We showed that excess burden of taxation results from distortion in compensated demands (substitution effects). It follows that the tax system which minimizes excess burden equalizes marginal distortions in compensated demands per dollar of additional revenue raised. (See Figure 4.1.) Copyright c 2008 by Michael Smart 1 Printed on: September 22, 2009 LECTURE 4. OPTIMAL TAXATION X MR MEB X X i i P i C C i 1+t +dt i 1+t...
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## This note was uploaded on 12/20/2009 for the course ECO ECO336 taught by Professor Smart during the Spring '09 term at University of Toronto- Toronto.

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Lecture 4 - 4 Optimal taxation 4.1 Introduction Previously...

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