Ch 20 Tax Inefficiencies

optimal commodity taxation

Choosing the tax rates across goods to minimize deadweight loss for a given government revenue requirement.

optimal income taxation

Choosing the tax rates across income groups to maximize social welfare subject to a government revenue requirement.

The Deadweight Loss of Taxing Wireless Communications

Demand for wireless communications is fairly price sensitive. There is already a large preexisting distortion in this market. The taxes are fairly high, and the marginal deadweight loss rises with the tax rate.

tax-benefit linkages

Direct ties between taxes paid and benefits received.

The 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 taxes across a large number of commodities and not tax any one commodity at a very high rate.

Vertical Equity

Social welfare is maximized when those who have a high level of consumption, and thus a low marginal utility, are taxed more heavily, and those who have a low level of consumption, and thus a high marginal utility, are taxed less heavily.

value of additional government revenues

The value of having another dollar in the government's hands relative to its next best use in the private sector.

What Is the Empirical Evidence on Tax-Benefit Linkages?

The existing literature suggests that the cost of social insurance financing is borne by workers in the form of lower wages and not lower employment.

Tax efficiency

The higher the tax rate, the larger the incremental deadweight loss of taxation.

Tax efficiency

The more elastically supplied or demanded the good, the larger the deadweight loss from the tax.

When Are There Tax-Benefit Linkages?

The tax-benefit linkage is strongest when taxes paid are linked directly to a benefit for workers.

Taxing cereal vs caviar

This outcome, while efficient, might violate a government's sense of tax fairness across income groups (vertical equity).

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.

The 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.

deadweight loss is caused by

individuals and firms making inefficient consumption and production choices in order to avoid taxation.

Deadweight loss rises with elasticities

the deadweight loss of a given tax is smaller when the demand curve is less elastic