ECN 131-Chapter 20

Two balanced factors of commodity taxing (Ramsey Rule)

1.Elasticity rule 2.Broad base rule

Issues raised by tax-benefit linkage analysis

1.If there is no inefficiency to providing a benefit, why doesn't the employer do so without government intervention? Adverse selection is at play here 2.When are there tax-benefit linkages? When the benefit is exclusive to those bearing the tax 3.What is the empirical evidence on tax-benefit linkages? On average, costs of financing these programs are largely paid through lower wages, with relatively little effect on employment. Cost of social insurance is borne by workers in the form of lower wages and not lower employment

Two principles on tax efficiency

1.More elastically supplied or demanded the goods, the larger the deadweight loss from the tax 2.The higher the tax rate, the larger the incremental deadweight loss of taxation

Pre-existing distortions

anything from externalities, imperfect competition, or existing taxes are key determinants of the efficiency of the new tax

Elasticities determine tax efficiency

as demand and supply elasticities rise, the deadweight loss of taxation grows

Behavioral responses

as taxes rise on any one group, individuals in that group may respond by earning less income to get taxed less. This means that an additional increase in taxes will raise less revenue because the base of the tax is smaller

Inefficiency of any tax

determined by extent to which consumers and producers change their behavior to avoid the tax; deadweight loss is caused by individuals and firms making inefficient consumption and production choices to avoid taxation

Tax-benefit linkages

direct ties between taxes paid and benefits received

Tax smoothing

governments should have relatively constant tax rates over time rather than high tax rates in some periods and low taxes in others; prevent high deadweight loss

Optimal commodity taxation theory

how can we raise a given amount of revenue with the least amount of distortion? choosing the tax rates across goods to minimize deadweight loss for a given government revenue requirement

Marginal deadweight loss

increase in deadweight loss per unit increase in the tax , rises with the tax rate accounts for tax efficiency

Broad base rule

it is better to tax a wide variety of goods at a moderate rate than to tax very few goods at a high rate because the marginal deadweight loss from a tax rises with the tax rate, the government should spread the taxes across a large number of commodities should be in balance with the elasticity rule

Deadweight loss

reduction in social surplus due to units that are not sold and that have a social marginal benefit exceeding their social marginal cost

Optimal income taxation

set of tax rates (and income transfers) across income groups; choosing the tax rates across income groups to maximize social welfare subject to a government revenue requirement 1.Vertical equity 2.Behavioral response

Vertical equity (optimal income taxation)

social welfare is maximized when those who have a high level of consumption and thus low marginal utility are taxed more heavily, and vice versa should be balanced with behavioral responses

Commodity taxation

taxation of goods

Inverse elasticity rule

taxing goods in inverse proportion to their elasticity of demand elastically demanded goods (higher ndi value) should be taxed less and inelastically demanded goods should be taxed more

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 mDWLi/MRi=λ tells us the optimal level of taxation across commodities

Elasticity rule

when elasticity of a good is high it should be taxed at a low rate and vice versa it should be in balance with the broad base rule

Value of additional government revenue

λ the value of having another dollar in the government's hands relative to its next best use in the the private sector (Norway's is rather large and so are their taxes)