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

north tax rate north dwc 20% south tax rate south dwc 0% average dwc Narrow tax base

average dwc north tax rate north dwc 10% south tax rate south dwc Broad tax base 10%

north tax rate north dwc 20% south tax rate south dwc 0% average dwc Narrow tax base

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