Public Sector Economics

Optimal Taxation
Optimal Taxation in the Logic of Public Finance
first determine how policy affects the economy
(dwl, winners and losers)
examples of duality, mechanism design
[closely related to I-O optimal pricing questions]
a positive theory of government

Optimal tax topics

inverse elasticity principle
tax reform
screening
taxation in-kind
 Deadweight Costs
resource and/or efficiency loss from tax evasion and
avoidance
derives from the microeconomic involuntary nature of
tax payments
taxpayers change their behavior to reduce their tax bill
beneficiaries change their behavior to increase their benefit
the behavioral change is often costly to the
taxpayer/beneficiary and to the treasury
like melting ice: $1 in taxes cost taxpayers more than $1,
and help beneficiaries less than $1
there is no close analogue in the private sector
higher tax rates lead to higher deadweight costs, and
at an increasing rate
 Narrow tax base
north dwc south dwc

average dwc

20% north 0% south

tax rate tax rate
 Broad tax base
north dwc south dwc

average dwc

10% north 10% south

tax rate tax rate
 Narrow tax base
north dwc south dwc

average dwc

20% north 0% south

tax rate tax rate
 A Tax Collection Principle
Minimize dwc of taxes per dollar of revenue,
eg., with low rates and broad base
not a trivial issue in practice. Consider
three federal taxes, 1994:
personal income tax: $543b with typical rate of
24%
payroll tax: $484b with rate of 12%
corporate tax: $140b with rate of 35%
basic principle behind The Flat Tax
 DWCs: Summary
in the corporate sector, creditors are (individually)
voluntary participants
government revenues are provided by (individually)
involuntary participants deadweight costs
hence, principles of public and corporate finance are
different
deadweight costs may be reduced when government is
widely held aka, tax base breadth
 Tax Reform Jargon
revenue neutral
CBIT = clean-base income tax
x tax
graduated rates on labor income without deductions
flat tax
single rate (or few rates)
on labor income
without deductions
cash flow tax a direct consumption tax (can be
graduated)
R-base tax: income tax with investment deductions
sales tax
VAT = value-added tax
 Optimal Screening
Favored group membership is like an occupation
e.g., poor,
elderly,
farmers,
persons with American Indian ancestors, etc.
free entry into a favored group is inconsistent with policies
that raise their utility
in the absence of natural entry barriers, lump sum transfers are not optimal
in-kind and other distortionary subsidies create deadweight losses, but
may raise entry barriers
literature
Stigler (1971) on occupational licensing
Becker (1983) and Gardner (1983) on farm subsidies
Nichols and Zeckhauser on socially optimal screening
some distortionary subsidies lower barriers