lecture8 - Applied Welfare Economics Part IIB: Paper 1 Dr...

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Applied Welfare Economics Part IIB: Paper 1 Dr Toke Aidt Lecture 8 Redistribution and Political Competition
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Outline Application of optimal tax theory to tax reforms “Benevolent” Governments versus “Actual” Governments Political competition and economic efficiency (deadweight cost) [The total cost of tax-transfer policies: Deadweight cost. Rent seeking cost.]
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Recap…. Full set of tax instruments and no untaxed profits. Production efficiency should be preserved Taxes levied to raise revenue and/or to finance redistribution should be levied on final consumer goods or primary factors of production. How? Mixture of Ramsey taxes and direct income taxes.
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Many-consumer Ramsey with indirect income tax Direct income tax (linear tax schedule) Many-consumer Ramsey with direct income tax One-consumer Ramsey model w. direct income tax Efficiency considerations Equity considerations Justifications for a high tax on final consumption goods or labour? Price inelastic goods Low budget share of the poor Price inelastic supply of labour Large lump sum component Pool tax No commodity taxes RULED OUT Price inelastic goods Low budget share of the poor OR Large lump sum component
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Practical application of the theory of Ramsey taxes Evaluating tax reforms
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Tax Reform Calculation of the optimal tax structure requires a lot of information: Specify explicit functional forms for utility functions. Specify the income distribution Estimate the compensated demand responses at the optimal . => Optimal tax theory of somewhat limited relevance for policymakers
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but… We can use the theory to make statements about tax reform, i.e., if it will be welfare improving to increase or decrease a tax from its current (in-optimal) level. This requires much less information and is of potentially great practical value.
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Ahmad-Stern Method i i t W t R i MRC = Marginal DWL of tax on good i weighted with the appropriate welfare weights. Marginal revenue raised from good i + = h h i h i ik k k k h h i h i i i x q X x q X q β ε τ MRC i = the revenue cost of generating an extra (marginal) unit of welfare by cutting the tax on good i. Distributional characteristics of the good Demand responses of total revenue Key point: All this can be estimated without knowing the optimum.
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Reform rule: Increase the tax on goods with a high MRC Decrease the tax on goods with low MRC The basic logic of Ramsey taxation: equalize the marginal deadweight cost per unit of revenue collected across all tax bases, …. so if the tax structure was optimal, then MRC would be the same for all goods (tax bases)! Ahmad-Stern Method
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lecture8 - Applied Welfare Economics Part IIB: Paper 1 Dr...

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