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TaxLecture2 - The Theory of Taxation Outline Tax Incidence...

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1 The Theory of Taxation: Outline Tax Incidence Application: the incidence of the corporate tax Optimal Commodity (Indirect) Taxation Optimal Income (Direct) Taxation Application: income transfer programs The choice between direct and indirect taxation Application: tax reform
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Taxation and Economic Efficiency Graphical Approach
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Taxation and Economic Efficiency Elasticities Determine Tax Inefficiency
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4 Optimal Commodity Taxation Ramsey Rule: To minimize the deadweight loss of a tax system while raising a fixed amount of revenue, taxes should be set across commodities so that the ratio of the marginal deadweight loss to marginal revenue raised is equal across commodities
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5 Optimal Commodity Taxation Inverse Elasticity Rule: When elasticity of demand for a good is high, it should be taxed at a low rate; when elasticity is low, the tax rate should be high
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6 Optimal Commodity Taxation Policy Implications: What should the relative taxes on caviar and bread be?
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7 Optimal Commodity Taxation However, the theory of optimal commodity taxation relies on the only tax instrument available to govt being the ( indirect ) taxation of market transactions In reality, a modern govt can typically observe the incomes earned by individuals, and tax these incomes directly
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8 The Theory of Taxation: Outline Tax Incidence Application: the incidence of the corporate tax Optimal Commodity (Indirect) Taxation Optimal Income (Direct) Taxation Application: income transfer programs The choice between direct and indirect taxation Application: tax reform
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9 Optimal Direct Taxation When the govt imposes direct taxes on individuals, issues of redistribution as well as issues of efficiency become relevant The theory of optimal direct taxation thus addresses both issues of equity and efficiency
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10 Example The theory of optimal direct taxation was originally developed by Mirrlees (1971) Many of its insights can be illustrated using a simple example with 3 individuals (A, B, and C) who differ in their productivities (and hence their wage rates) Each individual can work up to 10 hours/day
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