Taxation Summary

Ramsey Approach
-

Max HH Utility subject to resource constraint and the implementability constraint

Complete tax system: there are n independent instrument (all goods or n-1 goods + labor are
taxed)
Here: all taxes are distortionary because they enter the marginal conditions of the household
affecting the optimal consumption-labor choices
Household budget constraint is:
=1 =
Solving the Ramsey problem gives the following condition determining the relative tax rates
between two goods I and j:

Implication: if > then >

Goods with low price elasticity of demand should be taxed heavily => taxing inelastic goods
generates the smallest distortions (in partial equilibrium, not always in general equilibrium or
the utility function is additively separable and quasi-linear in labor)
If utility is separable across consumption and labor and it is homothetic consumption =>
uniform commodity taxation is optimal
Tax incidence (who bears the tax burden?) (the share of the tax bill) is dependent on the
price elasticity of demand and price elasticity of supply (not where the tax is collected).

Tax Share paid by consumer is: = =

o
o

True for any unit taxes as well as ad valorem taxes (based on the value, like VAT)
Ad valorem tax introduces a lower wedge between marginal revenue and marginal
cost
Change in Consumer Surplus: Mostly negative. It is the social cost of the tax. 1) The consumer
have pay more for each unit he is willing to buy ( ) . 2) Because of the higher price,
he will buy less.
Equivalent Variation (EV): It displays the differences of the old and the new level of utility in
monetary values. OR: How much money have to be taken away from the consumer before
taxes, so that he has the same utility level after taxes.
Compensating Variation (CV): How much money must the consumer receive after the tax, so
that he reaches the old level of utility again.
Excess Burden (EB):
o EB is higher for a tax applied to a good with a higher price elasticity of supply
o Taxing many commodities at a lower rate is better than taxing few commodities at a
higher rate

Inverse-Elasticity Rule

Corlett-Hague-Rule: Complements to untaxed goods should be taxed more heavily to archive

reduction in the untaxed goods without taxing them directly.
Summary of Rumsey results:
o Tax system should reduce the demand for all goods by the same proportion (it does
NOT imply that the tax rate on each good should be the same)
o With zero cross-elasticity, the optimal tax rate is inversely related to the own price
elasticity
o Solving the Ramsey (social planner) problem maps to competitive market equilibrium
o General equilibrium analysis: optimal tax rate, under additively separable utility (zero
cross- elasticitys) should be inversely related to income elasticity of demand
o Uniform taxation requires homothetic seperatability