UNIT 12 INTRODUCTION TO OPTIMAL

TAXATION
Structure
12.0 Objectives
12.1 Introduction
12.2 Some Concepts
12.2.1 Optimal Tax System
12.2.2 First Best Analysis and Lump-sum Taxes
12.2.3 Basic Structure of the Model

12.3 Optimal Commodity Taxation

12.3.1 Ramsey Rule
12.3.2 Inverse Elasticity Rule
12.3.3 Ramsey Rule: An Alternative Rule
12.3.4 Addressing Equity: Ramsey Rule and Social Justice

12.4 Optimal Income Taxation

12.4.1 Linear and Non-Linear Income Taxation

12.5 Conclusion
12.6 Let Us Sum Up
12.7 Key Words
12.8 Some Useful Books
12.9 Answers/Hints to Check Your Progress
12.10 Exercises

12.0 OBJECTIVES
After going through this Unit, you would be in a position to:
z explain what do we mean by an optimal tax system;
z identify the problems we encounter in optimal commodity taxation;
z how should the government impose taxes on different commodities to achieve
an optimal tax system;
z identify the trade-offs involved in optimal income taxation; and
z understand the relevance of optimal tax theory in designing a tax system.

12.1 INTRODUCTION
Recall that taxes distort the optimal choice of the taxpayers. Commodity taxes in the
form of different unit taxes change the price ratio faced by the consumer disturbing
thereby the equality between the marginal rate of substitution in consumption and
the price ratio as required by the Pareto efficiency. Similarly, income tax changes the 43
Economics of Taxation post-tax wage rate and as a result, the optimal choice between labour and leisure
gets distorted. Therefore, in the process of paying taxes, the taxpayers suffer a loss
of welfare. The burden arising out of such tax induced changes are called excess
burden (or, deadweight losses), which is over and above loss of income that the
taxpayers incur in terms of tax payment. While taxes are unavoidable, the objective
of the government should be to minimise the loss of welfare associated with excess
burden imposed on the taxpayers subject to a given revenue requirement while
designing a tax system.
Optimal tax theory can be guides for action, i.e., how can one use the theory of
optimal taxation to design a tax structure which conforms to the basic tenets of
economic theory such as ensuring efficiency and equity in the best possible manner.
For example, one can invoke optimal tax theory to address questions such as, how
to strike a balance between, direct and indirect taxes, how to determine the degree
of progressivity of the direct tax system, or how to choose an appropriate tax base.
The theory of optimal taxation seeks to address this age-old classic question in the
theory of taxation, which is relevant for any government dealing with tax policy
issues. The question what constitutes a good tax system dates back hundreds of
years. Though the leading economists like Smith, Mill, Edgeworth and Wicksell
dealt with some of these issues, it was only during the early 1970s that these issues
were systematically and comprehensively dealt with. One can however recognise
an echo of relevant issues in J. Dupuit in the middle of the nineteenth century. As far
as formal theorising is concerned, Frank Ramsey (1927) could be considered to be
the forerunner. His seminal contribution evoked responses for years to come and
paved the way for the development of literature. Later, Mirrlees (1971) contributed
in a big way to the advancement of the literature.
This chapter will give a brief outline of the essential elements of the theory of optimal
taxation. Keeping in mind, that the literature is vast and technical in terms of
specifications of the various models developed over the years, the approach adopted
here is to stress on the intuition behind the approach and the results derived there
from. We begin with a brief recapitulation of some of the basic concepts that you
have already studied in earlier units. The basic theory of optimal commodity taxation
is introduced which is followed by a discussion of optimal income taxation. We
round up the discussion with some issues to understand usefulness of this theory.

12.2 SOME CONCEPTS

Some concepts essential in the theory of taxation in order to appreciate the debate
and the context are discussed below.

12.2.1 Optimal Tax System

Recall that we define an allocation of resources in an economic system to be optimal
in terms of Pareto efficiency. A Pareto efficient allocation is obtained with regard to
a given distribution of resources or endowments. Since there can be many such
Pareto optimal allocations, depending on various configurations of initial distribution
of resources, such allocations are not comparable with one another. However, one
can rank the allocations in terms of some criteria such as equity or fairness. In similar
vein, Pareto efficient tax structure is one where there exists no alternative tax structure,
which can make at least one individual better off without making anybody else worse
44 off in the process. There can also be many Pareto efficient tax structures depending
on the initial distribution of income or endowments. However, one can choose an Introduction to Optimal
Taxation
optimal tax system which maximises social welfare by using a social welfare function.
This requires ranking the efficient tax structure in terms of equity criterion. In more
sophisticated models, equity and distribution of welfare are also assigned due
importance and the social welfare function is formulated to take this into account to
choose an optimal tax system.
However, there is disagreement as to what constitutes a good tax policy to achieve
the redistributional goals as per the objective of the government. Presence of a
trade-off between efficiency and equity complicates the problem. Generally speaking,
achieving greater equity entails higher tax rates. But inefficiency rises with the rise in
tax rates.
Optimality can also be defined in terms of other criteria. One can argue that a good
tax system is one, which minimises resource cost of the tax system. One could also
evaluate different tax systems in terms of justice and fairness. These aspects of
optimality will be discussed at the end of this Unit.

12.2.2 First Best Analysis and Lump-sum Taxes

First Best analysis means that the government has a set of policy options sufficient
for correcting whatever problems an economy has to restore the economy to the
bliss point on its first best utilities possibilities frontier. Second best analysis is defined
as the optimal policy of the government given that the bliss point is unattainable.
If efficiency is the only concern, an ideal tax system is one, which is consistent with
Pareto optimality. Imposition of lump-sum taxes, or, head tax as it is often referred
to as, offers the classical solution as this kind of tax does not affect the optimum
configurations attained by the consumers and the producers. Since, this kind of tax
does not interfere with the decision making of the consumers and producers as
neither income nor prices, which determine the equilibrium configurations, gets
affected. Therefore, it would have been ideal if the government could mobilise revenue
only through this tax as the essential properties of a Pareto optimal allocation would
have remained satisfied. Unfortunately, in a real world it offers no solution to a
policy maker. Imposition of this tax is tantamount to treating all taxpayers on equal
footing, which is unethical. It is impractical as well to rely on this tax as the only
source. The government is always therefore in a Second Best environment where
the government is left with no choice but to levy distortionary taxes. Moreover,
other conditions necessary for a market efficient outcome like perfect competition
and absence of externalities are difficult to obtain in a real world.
However, there are taxes other than lump-sum taxes, which satisfy Pareto optimal
conditions. Under certain conditions, it has been shown that taxes on profits are
neutral as the optimising decisions of the producers and consumers remain unaltered.
In presence of externalities, Pigouvian taxes (or, subsidies) can correct for deviations
between private costs (or, benefits) and social costs (or, benefits) and help achieve
Pareto optimal conditions. As in the majority of the cases, markets associated with
externalities are ‘missing’ or non-existent. In such cases, determining a Pigouvian
tax structure to achieve optimality would not be feasible.

12.2.3 Basic Structure of the Model

The literature consists of a wide range of models that focus on particular aspects of
the tax system. However, these models share three basic features. First, each model 45
Economics of Taxation specifies a set of taxes the government wants to levy and revenue the government
wants to collect. The second feature is the specification of the economic agents,
individuals and the firms in terms of their responsiveness towards taxes, preference
pattern of the individuals about goods and leisure, technology of the firms and how
do they interact in a market structure, often in the context of perfect competition.
Third, the government has an objective function which specifies what does the
government intend to achieve. In a simple model, the objective of the government is
to minimise excess burden subject to a given amount of revenue.
Check Your Progress 1
1) What is the difference between a Pareto efficient tax structure and an optimal
tax system?
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2) Why cannot we rely solely on lump-sum taxes? Distinguish between first best
and second analysis?
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3) What do you mean by an optimal tax system? How is it obtained?
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12.3 OPTIMAL COMMODITY TAXATION

In the basic framework of optimal commodity taxation, the government seeks to
raise a given amount of resources with the levy of only commodity (including both
goods and factors) taxes. The objective of the government is to find out, what set of
commodity taxes would minimise the efficiency cost of the tax burden to raise a
required amount of revenue. The simplest version of the Ramsey model is a static
model (i.e., one period model without saving) with a representative consumer.

12.3.1 Ramsey Rule

Ramsey rule (1927) requires that the optimal set of commodity taxes leads to an
equal percentage reduction in the compensated demands for all goods and factors.
Recall that compensated demand for a good is derived by keeping utility constant
consequent upon a price change and assessing how demand changes with a change
46
in the relative price only. Compensated demand therefore captures only one
component of price effect, i.e., the substitution effect as the concern of the theory of Introduction to Optimal
Taxation
optimal taxation pertains to excess burden. By way of clarification, since optimality
pertains to allocation in terms of quantities, Ramsey rule demands “equal-percentage-
change” in the quantities of each good (or factor) rather than equal percentage change
in the prices as implied by uniform taxation.
Ramsey (1927) showed that a uniform commodity tax system, which does not change
the relative prices is, in fact, rarely optimal. It may appear that taxing goods and
services at a uniform rate would be optimal, as relative prices remain unchanged.
However, this is just a tax on income as real incomes falls with the rise in nominal
price level on account of a rise in prices of all goods and services rise by the same
magnitude. Uniform set of taxes may therefore appeal to the policy makers apparently
because relative prices remain unchanged and optimal decisions are satisfied. But
ultimately it is the price – induced change in demand which matters. So, imposing a
uniform rate of tax on a good whose compensated demand is relatively elastic would
generate less revenue as well as greater inefficiency as demand changes relatively
more.

12.3.2 Inverse Elasticity Rule

The Inverse Elasticity Rule (IER) is often used in policy making as an approximation
for equal percentage change. Let us assume that demands for different goods are
unrelated, i.e., cross price elasticity of demand are zero along with zero income
effects. Under certain conditions, Ramsey rule simplifies to the ‘Inverse Elasticity
Rule’: the tax rate is inversely proportional to a good’s own compensated elasticity
of demand. Taxes should in fact vary across the commodities such that goods with
lower elasticity attract higher tax rates, as the extent of price change is smaller than
goods with higher elasticity. In order to minimise substitution effect, elastic goods
should be subject to lower tax rates and vice versa to keep distortions and, thereby,
deadweight losses at minimum as mentioned earlier. The exemption of grocery from
taxes is an example, which is counter to the basic Ramsey rule because grocery
demand is relatively inelastic. But in order to make sales tax less regressive, these
items are generally exempt for equity reasons.
Tax as a proportion of consumer price is inversely related to the price elasticity of
demand. The Rule can be expressed as follows,

ti k k
= + s
pi ε P η

Where ti is the per unit tax on commodity (or factor) i, pi is the post-tax price, ε P is
the compensated price elasticity of demand, çs is the elasticity of supply, and k is a
proportionality factor that depends on the total amount of revenue that the government
seeks to raise. Assume that elasticity of supply is infinite (a horizontal supply schedule)
so that (k/çs) tends to become zero. Recall that the extent of change in price-quantity
equilibrium configuration depends also on the slope of the supply schedule. Therefore,
assuming supply elasticity to be infinite, higher the price elasticity, lower should be
the tax rate, hence the Inverse Elasticity Rule. As a consequence, taxpayers would
tend to move away from the highly taxed commodities to the lightly taxed
commodities.
For two goods i and j, Ramsey rule can be expressed as follows. Let rates of tax ti
and tj be levied on i and j. Taxation is efficient when the combination of ti and tj 47
minimises the combined excess burden in the two markets i and j subject to collection
Economics of Taxation of a given amount of revenue, say R. Efficient tax rates of ti and tj therefore minimise
the sum of excess burden in the two markets i and j as follows,
Minimisation of (Excess burden in i + Excess burden in j) subject to fulfilment of the
revenue target of the government R = ti PiQi + tj PjQj where, Qi and Qj are the
quantities of i and j respectively sold in the market at prices Pi and Pj respectively .
Market structure is assumed to be competitive and supply is at constant costs. The
above problem yields the following expression,

It indicates that tax rates on two goods should be inversely related to the demand
elasticities of i and j.

How do we determine the pattern of taxes such that deadweight loss is minimum?
Optimality requires that the t i taxε rates should be determined in a manner such that
=
j

t ε
increase in deadweight lossj per extra i rupee collected is the same for each good (or
factor). If the equality is not maintained, there exists a possibility of changing the tax
rate so as to bring down the extent of deadweight losses by moving away from the
good with higher marginal deadweight loss to the lower one until equality is restored.
Optimal Commodity taxation: The marginal excess burden (deadweight loss) for
marginal dollar raised must be the same for all commodites.

Marginal Tax Revenue

Income

Commodity i
Commodity j

Extra dead weight loss from

raising an extra dollar of revenue

t*i t*j t

Fig. 12.1: Marginal Deadweight Loss

48
The figure 12.1 depicts the solution to the optimal commodity tax problem. The Introduction to Optimal
Taxation
ratio of the increase in deadweight loss to the tax revenues from raising the tax rate
by a very small amount – that is marginal deadweight loss from raising an extra
rupee from a tax on commodity i is computed. This has to be equally true for any
other commodity, say j, as well.

12.3.3 Ramsey Rule: An Alternative Rule

There is an alternative interpretation of Ramsey rule. In a three good economy,
efficiency implications are studied in which labour (or leisure) enters the utility function
as a third argument. In presence of leisure, commodity taxes make commodities
dearer and leisure cheaper. What the optimal tax theory (Corlett and Hague 1953)
does is to take advantage of substitutability and complementarity between
commodities and leisure and proposes that optimal tax rates on different goods
should depend upon the demand for the goods and its relationship with leisure.
Those which are complementary to leisure such as watching movies should be taxed
at higher rates and those which are substitutable (but complementary to labour)
such as, uniform (or attire) or other work related expenses should be taxed at lower
rates. This is how untaxed leisure gets taxed in an indirect manner.

12.3.4 Addressing Equity: Ramsey Rule and Social Justice

Ramsey rule can even contradict equity or social justice as efficiency is the only
focus of such a rule. In the 1970s, it was realised that concentrating only on efficiency
aspects independent of equity effects would not be meaningful at least with respect
to practical applications in a many person economy. It seems that Ramsey rule
requires luxury goods with generally high price elasticities are to be taxed at lower
rates and necessities with low elasticities are to be taxed at higher rates. This way of
taxation is inegalitarian as the poor consume more of necessities and less of luxury
goods and vice versa for the rich.
Now suppose that the taxpayers differ with regard to their endowments. Apart from
being concerned with minimisation of efficiency cost alone, the question of distribution
of consumer welfare assumes importance. But in presence of income taxes, the
income tax structure can be so designed so that it can bear the entire burden of
distribution. Commodity taxes may therefore cease to become part of the optimal
tax structure (Atkinson and Stiglitz 1976). However, there may be administrative
reasons for resorting to indirect taxation.
If variation in the tastes of the consumers are recognised and concern for fairness of
the tax system is explicitly taken into account, a social welfare function is introduced
which allows for higher weights for disadvantaged (or poor) households and lower
weights for the privileged (or rich) to render the tax system more equitable. The
basic problem gets modified in the following manner. Percentage reduction in goods
consumed by the disadvantaged who are favoured by the government is smaller
than the percentage reduction in the goods consumed by the households with lower
weights in the social welfare function. Equity considerations are taken into account
as higher taxes are imposed on goods, which are predominantly consumed by the
rich.
Check Your Progress 2
1) What is Ramsey rule for optimal commodity taxation?
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Economics of Taxation ...................................................................................................................
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2) What is Inverse Elasticity Rule? Explain the intuition behind the Rule.
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3) Why Ramsey rule may be called inegalitarian? How can it be mitigated in
presence of leisure?
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12.4 OPTIMAL INCOME TAXATION

The analysis of optimum income taxation became an important area of research
during the 1970s as personal income tax gained importance as a major source of
revenue in the developed countries. Since income tax could be designed so as to
consider individual characteristics such as tax paying capacity, it could be considered
as a major instrument for achieving redistributional goals. But efficiency-equity trade
off remained an important aspect of the debate. Higher the tax rates greater the
inefficiency costs imposed on the taxpayers but greater would be the ability of the
government to carry out redistribution.
Income tax has three main sources of inefficiencies or ‘leaks’, which are popularly
referred to as Okun’s leaky bucket, named after the economist Arthur Okun. They
are as follows,
Dead-weight losses arising from distorting income tax in labour and capital market.
Administrative costs of tax collection including costs of tax enforcement and monitoring
tax revenues.
Compliance costs incurred by the taxpayers to comply with tax laws (which is over
and above taxes paid) as well as to reduce tax liabilities legally and illegally and
costs of compliance incurred by the third party, such as banks and the judicial
machinery. Elements of compliance costs would include expenses related to filing
return, fees paid to tax advisers, costs of appeal, etc.
The fundamental problem encountered in optimal taxation of income is to strike a
balance between the gains from redistribution and the three inefficiency costs as
mentioned above. It was James Mirrlees who provided the first complete analysis
of optimal income taxation by incorporating only labour market inefficiencies in a
50 social welfare framework.
The basic model is static and hence disregards saving decisions or capital income. Introduction to Optimal
Taxation
However, in later models, inter-temporal saving and investment decisions are also
included.

12.4.1 Linear and Non-linear Income Taxation

Static models are of two types: linear and non-linear (general) income taxes. Linear
income tax models have two parameters, a lump-sum tax (or a lump-sum grant to
each individual) and a fixed marginal tax rate. The marginal tax rate creates
disincentive for the supply of labour and thereby distorts the decision of the workers.
It is thus associated with an efficiency cost. Let Y indicate income as earned by the
individual, R is the value of total tax revenue paid by the individual, S is the income
subsidy given by the government. Total taxes paid by an individual is therefore,
R = -S + t.Y
All individuals receive an income transfer from the government and all of them face
the same marginal tax rate. It is clear, in view of the budget constraint of the
government, that the rate of taxation determines the amount of income transfer which
could be financed. It brings into focus the trade-off between inefficiency caused by
the tax rate and the redistributional goals the government intends to achieve.
The government can choose both the parameters and can raise revenue and
redistribute revenue across income groups. The optimal choice of parameters
depends on (1) how much revenue does the government need to collect, (2) society’s
preference for redistribution as reflected in the social welfare function, (3)
responsiveness of the labour supply decisions to post-tax wage, and (4) the
distribution of the pre-tax wage in the economy, or, to put it differently the inequality
in the pre-tax income distribution.
However, the tax schedule need not be linear. In practice, we obtain non-linear tax
schedules, which is progressive. The rationale behind designing a progressive tax
schedule is provided by the concept of vertical equity as discussed in Unit 11.
Mirrlees (1971) initiated an interesting debate how progressive an income tax structure
should be. In his framework, the government seeks to maximise a utilitarian social
welfare function and has to determine an income tax schedule subject to collection
of a given amount of revenue. In the non-linear income tax systems, marginal tax
rate changes with the change in income level. The goal of the government remains
one of raising revenue with minimum distortions in an equitable manner. The distortions
are created as in the linear tax model by the non-zero marginal tax rate on labour
supply decisions.
Suppose we would like to determine the general optimal income tax structure that
maximises a social welfare function. We are, in effect, looking for a relationship
between the tax rate and earned income that could be progressive as well as
regressive, at least in principle. Let us assume a smooth income tax schedule as
follows,
t = f(Y)
The solution to the problem tells us how to set the tax rate t for all levels of income.
Finding an optimal income tax schedule entails a compromise between progressive
taxation to achieve social justice and at the same time, progressivity causing inefficiency.
The efficiency question is addressed if we know response of the taxpayers towards 51
Economics of Taxation work and leisure. If the government thinks that inefficiency caused by high tax rate
need not be a matter of concern and empirical estimates show that work and leisure
substitution is low and people pay in accordance with their ability, a highly progressive
tax structure may be opted for. If the government instead emphasises more on the
extent of ‘leaks’ causing inefficiencies and the excess burden caused by progressive
taxation and less on equity, the decision makers would advocate a moderate tax
schedule or, low progressivity.
It may be mentioned that ideally government could impose tax on the innate ability
of the taxpayer, which would have been non-distortionary. But the government cannot
observe ability and hence government has to tax income, which is taken to be a
proxy for ability. In presence of heterogeneous taxpayers, one has to take note of
income elasticity of commodities and importance assigned in terms of social weight
to redistribution of welfare for designing an optimal tax system.
The important results which follow from above formulation are as follows:
The marginal tax rate should lie between zero and one.
The marginal tax rate for the person with the highest income should be zero.
If the person with the lowest income (or hourly wage rate) is working at the optimum,
then the marginal tax rate should be zero.
What follows with general tax schedules is that marginal rates do not rise uniformly
throughout the range of income. The actual tax schedule however imposes tax burden,
which rises with the level of income.
In order to understand the intuition behind the second result, let us suppose that
there are two tax schedules. In the first one, the tax rate on the highest income
earner is positive and in the second one, the marginal tax rate at the top of the
income ladder is reduced to zero. The taxpayers faced with the second tax schedule,
may decide to work more in response to an increase in post tax income. So the
effect of setting a tax rate at zero for the highest income earner results in a Pareto
optimal situation as welfare of the highest income individual increases and the
associated gains in social welfare and even the government collects for revenue.
What follows is that optimum tax schedule must have a schedule of rising marginal
rates near the bottom and a segment of declining marginal rates near the top. This
contradicts most of the characteristics of an actual income tax schedule. The logic
that an optimal schedule should necessarily have zero tax rate at the top applies only
to the individual at the top of the income bracket and does not throw any light on
how marginal income tax rate should be just below the top income level. From a
practical point of view, it is virtually impossible to ascertain the top of the income
level in the income distribution.
For lowest income individual, the question of redistribution would not arise as there
is no taxpayer with lower income to gain from redistribution. So there is no rationale
for imposing inefficiency causing tax on the lowest income individual in absence of
any gain from redistribution.
Check Your Progress 3
1) Explain the trade-off you would face in deriving the properties of an optimal
income tax system?
52 ...................................................................................................................
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Taxation
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2) What are the main results obtained from the non-linear optimal income taxation?
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3) Explain the intuition behind fixing the income tax rate for the highest income
earner at zero?
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4) Do you think that the theory of optimal tax system is relevant for tax policy
issues?
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12.5 CONCLUSION
An analysis of optimal taxation has bridged the gap between welfare economics and
realities of public policy to a large extent. The optimal tax theory addresses specific
questions like, should additional revenue be mobilized by introducing a value added
tax or by raising tax rate on income or even by strengthening tax administration.
Since the optimising taxpayers have incentives to exploit private information, which
may not be available with the government, how to deal with dishonest taxpayers
remain an important challenge for the government. The questions optimal tax theory
seeks to answer are essentially normative but policy prescriptions in public economics
are in the realm of positive analysis. The normative approach provides a framework
for examining the policy questions and it can essentially be a guide for policy issues.
However, what the government can do depends on information availability with the
government in setting up a tax system.
Ramsey rule was found to be inequitious. It is not surprising as the focus is mainly on
minimisation of inefficiency or excess burden. In practice one has to assign different
weights in the social welfare function to resolve this crucial trade-off between
efficiency and equity objectives. Based on empirical measures of elasticities, the
government can find out tax rates to be applied, which is right for the economy,
given the objective. Take for example the case of the salaried individuals. Given 53
Economics of Taxation their nature of work, higher tax rates would cause very little distortion unless they
decide to quit the job market and do something else as the possibility of substitution
is very limited. One has to therefore examine the reality against the backdrop of the
underlying assumptions of the model. Given the complexities involved, actual
determination of the tax schedule often boils down to a political decision. Under
different valuation of the objectives, the government would come up with different
tax schedule. The optimal tax theory provides reliable intuition with well-founded
arguments, which are important for policy decisions in taxation.
The theory is yet to come to terms with the very fact that imposition of taxes entails
resource costs incurred by the taxpayers and other supportive institutions like banks,
courts, police and most importantly tax administration. The resource cost varies
with the tax instruments, rate structure, tax administration and extent of tax evasion.
It is suggested that there is a need for an optimal tax system, an alternative to the
conventional optimal taxation, which would minimise resource cost (Slemrod 1990).
Tax compliance cost, the third of Okun’s leaky bucket is an important cost item of
the total resource cost incurred by the society. Optimal tax theory emphasises mainly
upon labour and capital market imperfections.
In tax policy matters, the government therefore is assigned with a very challenging
task. New insights have been gained into the mode of balancing various conflicting
objectives of the economy, such as efficiency and equity. The optimal tax theory
makes an important contribution to the decision making process in identifying issues,
the dilemma, the hard choices the government has to confront with and their
implications on the economy in a theoretical framework. Whether optimum tax
formula can be taken seriously in designing a tax system remains a moot question
when resource costs, or, the other two sources of ‘leaks’ are kept out of purview.

12.6 LET US SUM UP

Imposition of taxes entails various types of costs inflicted on the taxpaying community.
Excess burden arising out of inefficiency is one such cost, which becomes the prime
focus of the government in determining the optimal tax structure. The government
seeks to find out a configuration of taxes such that excess burden is minimised subject
to the given revenue of the government. The concept of Pareto efficiency is used to
derive a Pareto efficient tax structure, which is a set of taxes so that no body can be
made better off without making anybody else worse off. The choice of an optimal
tax structure would depend on social justice or to put it differently, maximisation of
the social welfare function. Ramsey rule provides us a clue as to how we can achieve
optimal commodity taxation. It argues that apparently simple solution of uniform
taxes is not the one. The rule requires that higher taxes to be imposed on the goods
with lower elasticities to keep substitution at minimum. In presence of leisure we can
achieve equality albeit to a limited extent by taxing those goods, which are
complements to leisure. In optimal income taxation, the idea is to strike a balance
between inefficiency and equity. At the same time, higher tax rates cause distortion
and thereby impose excess burden. Higher revenue collected through higher tax
rates enable the government to carry out redistribution. It was discussed why the
choice of the tax structure is a matter of political choice because the results suggested
by the optimising exercise depends on values attached to equity and efficiency in the
social welfare function.

54
 Introduction to Optimal
12.7 KEY WORDS Taxation

Pareto Efficient Tax Structure : It is a tax structure when there exists no other
tax structure which makes at least one
individual better off without making anyone
else worse off.
Optimal Tax System : It is a Pareto efficient tax structure which
maximises a given social welfare function.
First Best Analysis : Deals with economies where all the Pareto
efficiency conditions are satisfied. First best
theory is quite unrealistic as it ignores a number
of important real world situations that the
policy matter cannot afford to ignore. The
government has, at its disposal, all the policy
tools like imposition of lump-sum taxes and
lump-sum redistribution to achieve maximum
social welfare or ‘bliss point’.
Theory of Second Best : The theory is concerned with the design of
Analysis government policy in an economy where there
exist some important distortions like imperfect
market structure, which cannot be removed.
The government cannot use lump-sum tax or
lump-sum redistribution. Further, it tells us that
where we cannot apply the lessons of first
best analysis as it is often difficult to know
when the government should intervene and in
what manner. Since there can be numerous
restrictions, the possibilities for Second best
analysis are endless.
Compliance Costs of Taxes : Costs incurred by the taxpayers in order to
comply with the tax obligations as per Tax
Laws over and above the costs arising out of
distortions.
Lump-sum Taxes : It is generally called head tax when the taxable
amount is determined independent of the
taxpayers’ characteristics.

12.8 SOME USEFUL BOOKS

Andmo, Agnar, 1976, Optimal Taxation: An Introduction to the Literature, Journal
of Public Economics, 6, pp. 37-54.
Diamond, P.A. and Mirrlees, J.A. Optimal Taxation and Public Production I-II,
American Economic Review, 61, 8-27, 261-78.
Hillman, A L. (2003) Public Finance and Public Policy: Responsibilities and
Limitations of Government, Cambridge University Press, Cambridge, UK.
Mirrlees, J. (1971) “An Exploration in the Theory of Optimum Income Taxation,” 55
Economics of Taxation Review of Economic Studies, April.
Slemrod, Joel (1990) Optimal Taxation and Optimal Tax Systems, Journal of
Economic Perspectives, 4,1, Winter.
Stiglitz, Joseph E., 2000, Economics of the Public Sector, Third Edition, W. W.
Morton & Company, New York.
Tresch, Richard W., (2002) Public Finance: A Normative Theory, Second Edition,
Academic Press, USA.

12.9 ANSWERS/HINTS TO CHECK YOUR

PROGRESS
Check Your Progress 1
1) See Sub-section 12.2.1.
2) See Sub-section 12.2.2
3) See Sub-sections 12.2.1 and 12.2.3
Check Your Progress 2
1) Go through Sub-section 12.3.1.
2) See Sub-section 12.3.2.
3) See Sub-sections 12.3.2 and 12.3.4.
Check Your Progress 3
1) Go through the first paragraph of 12.4 and explain with illustration from Sub-
section 12.4.1.
2) Discuss the three main results obtained under non-linear taxation from Sub-
section 12.4.1.
3) Go through the explanations given to the results referred to in the last part of
the Sub-section 12.4.1.
4) Examine the assumptions and the approach of optimal taxation models. The
reference to Okun’s leaky bucket would be of help. You may go through Sections
12.5 and 12.6 as well.

12.10 EXERCISES
1) Ramsey rule can be inegalitarian in case of personal income taxes also. Explain
with examples.
2) Do you think that the theory of optimal tax system is relevant for tax policy
issues?
3) Why the actual income tax schedule obtained in practice differ from an optimal
income tax schedule?

56
Notes
 MEC- 006 : PUBLIC ECONOMICS
Block 1 Public Economics: The Basic Concepts
Unit 1 : Welfare Foundations of Economic Policies
Unit 2 : Theory of Market Failure
Unit 3 : Voting and Local Public Goods
Block 2 Social Choice and Collective Decision making
Unit 4 : Arrow’s Impossibility Theorem: Social Choice and Individual
Values
Unit 5 : Normative Models : Equity and Justice
Unit 6 : Spatial Voting Models
Block 3 Public Policy : Mechanism Design, Agenda Setting
and Information
Unit 7 : The Basics of Public Policy
Unit 8 : Mechanism Design
Unit 9 : International Policy Coordination
Block 4 Economics of Taxation
Unit 10 : Commodity Taxes
Unit 11 : Direct Taxes
Unit 12 : Introduction to Optimal Taxation
Block 5 Public Debt
Unit 13 : Theory of Public Debt
Unit 14 : Sources of Public Debt
Unit 15 : Management of Public Debt
Block 6 Fiscal Federalism
Unit 16 : Fiscal Federalism and Fiscal Policy
Unit 17 : Equity and Efficiency Issues
Unit 18 : State and Local goods

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