UNIT 10 COMMODITY TAXES

10.1 Objectives
10.2 Sources of Public Income
10.3 Theory of Commodity (Indirect) Taxation
10.4 Partial Equilibrium Analysis
10.4.1 Single Commodity
10.4.2 Multiple Commodities
10.4.3 Summary

10.5 The Ramsey Tax Model

10.5.1 The Model
10.5.2 Equivalence between Wage Tax and Commodity Taxes
10.5.3 Indirect Utility Function
10.5.4 Lump Sum Tax
10.5.5 Summary

10.6 Partial Welfare Improvements

10.6.1 Partial Welfare Improvements
10.6.2 Horizontal Equity
10.6.3 Tax Reform
10.6.4 Summary

10.7 Let Us Sum Up

10.8 Key Words
10.9 Some Useful Books
10.10 Answers/Hints to Check Your Progress
10.11 Exercises

10.1 OBJECTIVES
The objective of this lesson is to introduce you with the theory of commodity (indirect)
taxation. As we all know, the government needs revenue to discharge its
responsibilities. Among the sources of revenue, taxes are one of them. But for the
analytical sake, we shall assume that the source of financing is only taxes. These
taxes may classified as indirect (on outputs) and direct (on factors) taxes. After
going through this unit carefully you would be able to:
z rationalize the taxation of the commodities on the basis of equity and/or efficiency
grounds;
z understand whether different commodities should be taxed at the same rate or
differentially;
z appreciate whether a particular form of taxation contributes or lessen the welfare
of the individuals; and
z analyse whether reforms the country is undergoing are helping the country and
in what manner and many other issues that may be sorted out on the prevalent
1
theoretical underpinnings.
Economics of Taxation
10.2 SOURCES OF PUBLIC INCOME
Government derives receipts through various sources to finance expenditure, whether
transfers or purchases, and to pay off public debts. They are classified as taxes,
non-taxes, grants-in-aid and public debts. Generally non-taxes are the prices paid
voluntarily, whereas taxes are paid compulsorily, putting aside the charge that they
are never morally justifiable. The economic rationale of levying taxes is:
1) To bring about optimum and efficient resource allocation within the economic
system.
2) To help accelerate the rate of savings and investment, which is an extension of
resource allocation.
3) To reduce inequalities in income, wealth or consumption.
4) To check price rise and inflationary tendencies.
5) To promote employment opportunities, which is a case of stabilization.
General taxes are divided into two categories: taxes on factors (direct) and taxes on
commodities (indirect) falling on outputs. It may also be noted that frequently used
distinction between “direct” and “indirect” taxes is ambiguous. The tax system
develops in response to several economic, political and social influences. Musgrave
and Musgrave (1989) have listed following criteria to appraise the quality of a tax
structure:
1) The distribution of the tax burden should be equitable. Everyone should be
made to pay his or her “fair share”.
2) Taxes should be chosen so as to minimize interference with economic decisions
in otherwise efficient markets. Such interference imposes “excess burdens”
which should be minimized.
3) Where tax policy is used to achieve other objectives, such as grant investment
incentives, this should be done so as to minimize interference with the equity of
the system.
4) The tax structure should facilitate the use of fiscal policy for stabilization and
growth objectives.
5) The tax system should permit fair and nonarbitrary administration and it should
be understandable to the tax payer.
6) Administration and compliance cost should be as low as is compatible with the
other objectives.
Since our focus here is taxes on commodities, which are often called as indirect
taxes, let us recall and have a bird’s view of their relative fiscal importance in Indian
public finances. The Table shows that there has been a gradual shift away from
direct towards indirect taxes since 1950-51 to date, particularly in case of states
own taxes. Aggregate data shows, while the ratio of indirect taxes was 63.16 per
cent and by 2003-04 this ratio increased to 74.19 per cent. It was even more than
86 per cent during the period. For the Central government, it was 56.54 per cent in
1950-51 and in 2003-04 this ratio was increased to 59.44 per cent. It also peaked
to 80.44 per cent during the period. Similarly, at State level, these ratios were 75.25
2 per cent and 97.21 ratio respectively.
 Table 10.1 : India: Trends of Composition of Taxes by Level of Commodity Taxes
Governments – Select Years during 1950-51 to 2003-04

Fiscal All-India Centre's Gross Taxes State's Own Taxes

Direct Indirect Direct Indirect Direct Indirect
1950-51 36.84 63.16 43.46 56.54 24.77 75.23
1960-61 29.78 70.22 32.63 67.37 24.18 75.82
1970-71 21.23 78.77 27.11 72.89 9.06 90.94
1980-81 16.47 83.53 22.74 77.26 4.07 95.93
1990-91 13.98 86.02 19.16 80.84 4.08 95.92
2000-01 23.50 76.50 36.22 63.78 2.96 97.04
2001-02 23.24 76.76 36.99 63.01 3.07 96.93
2002-03 24.52 75.48 38.61 61.39 2.85 97.15
2003-04 25.81 74.19 40.56 59.44 2.79 97.21
Let us know that the governments are interested to raise certain level of amounts as
through taxes. Then arises the issue of raising them either by taxing income
(on labour as direct taxes) or consumption (on commodities or services as indirect
taxes). Both these have relative merits and economic impacts on the taxpayers. The
composition changes on the perceived favour by the policy makers of one category
over other.
In the following sections we shall try to understand the rationale and theory of indirect
taxes. Let bear in mind that theories are always terse but when one thinks on them,
can criticize them and rationalize the issues under consideration.

10.3 THEORY OF COMMODITY (INDIRECT)

TAXATION
According to conventional wisdom, there is a definite preference for a uniform rate
structure, and this view appears to influence government policy-making. This is based
on efficiency considerations: a differentiated structure has greater distortionary effects.
A second, and quite different, which holds that conventional argument for a uniform
system of taxation is that of equity between consumers. A general sales tax or value
added tax on all expenditure at a single rate would be fair as everyone would pay
the same tax on all their expenditure. Contrarily, non-uniformity results in discrimination
against people having particular preference for more heavily taxed goods.
In assessing these arguments for uniform taxation, it is helpful to discuss the efficiency
and equity aspects separately, since the considerations involved are different. In
following three sections, in order to simplify the matter, we shall be using analysis of
a model where all individuals are identical, and are assumed to be treated identically.
No distributional issues therefore arise, and we concentrate on the efficiency question
as to whether from the allocational standpoint, a uniform tax is preferable to a
differentiated structure.

10.4 PARTIAL EQUILIBRIUM ANALYSIS

Uniform rates are not in fact necessarily desirable from an efficiency standpoint.
This can be demonstrated by simple partial equilibrium analysis, where there are no
cross-price effects and therefore relevant income derivatives are zero.
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Economics of Taxation 10.4.1 Single Commodity

Fig. 10.1: Excess burden from tax on good k

Let us assume that the supply of good k is perfectly elastic at price pk, so that the
equilibrium in the absence of taxation is at point E in Figure 10.1. The effect of an ad
valorem tax at rate tk is to raise the consumer price from pk to (1+tk). The after-tax
equilibrium is at point B in this partial equilibrium framework the distortion caused
by the tax is often measured by the loss of consumer surplus over and above the
revenue raised, the “excess burden”.
The excess burden is thus the additional cost of rising given revenue through
distortionary taxation. In economics, an excess burden (also known as deadweight
loss) is a loss of economic efficiency that can occur when equilibrium for a good or
service is not Pareto optimal. In other words, either people who would have more
marginal benefit than marginal cost are not buying the good or service or people
who would have more marginal cost than marginal benefit are buying the product.
If we take the area ABECD as a measure of the loss of consumer surplus, the
excess burden is represented by the shaded area BCE.
Area BCE = Area BEFGC – Area CEFG

where X k0 denotes the equilibrium quantity before the tax is introduced, X kt that
after the tax is introduced. The excess burden is therefore zero for infinitesimal taxes
(i.e., evaluating at tk = 0)1.
Causes of deadweight loss include monopoly pricing, externalities or taxes or
subsidies. The term deadweight loss may also be referred to as the “excess burden
of monopoly” or the “excess burden of taxation”.
For example, consider a market for pens where the cost of each pen is Rs. 10 and
that the demand will decrease linearly from a high demand for free pens to zero
demand for pens at Rs. 10. In a perfectly competitive market, producers would
have to charge a price of Rs. 10 and every customer whose marginal benefit exceeds
Rs. 10 would have a pen. However, if only one producer has a monopoly on the
product, then they will charge whichever price will yield the highest profit. For this
market, the producer would charge Rs. 60 and thus exclude every customer who
had less than Rs. 60 of marginal benefit. The deadweight loss is then the economic
benefit forgone by these customers due to the monopoly pricing.
Conversely, deadweight loss can also come from consumers buying a product even
4 if it costs more than it benefits them. To see this, let’s use the same pen market, but
instead it will be perfectly competitive with the government giving a Rs. 3 subsidy to Commodity Taxes
every pen produced. This Rs. 3 subsidy will push the market price of each pen
down to Rs. 7. Some consumers then buy pens even though their benefit to them is
less than the cost of Rs. 10. This unneeded expense then creates the deadweight
loss.
There are two important concepts of deadweight loss due to Hicks and Marshall
with a distinction. The latter is related to the concept of consumer surplus, such that
it can be shown that the Marshallian deadweight loss is zero where demand is perfectly
elastic or supply is perfectly inelastic. On the other hand, Hicks analysed the situation
through indifference curves the policy or economic situation which caused a distortion
in relative prices will have an income effect and that this income effect is a deadweight
loss.

10.4.2 Multiple Commodities

Now let us turn to a situation of many commodities. We know that the ‘excess
burden’ of taxation represents an efficiency loss, which must be compared with any
perceived gains arising either from income redistribution or the non-transfer
expenditure carried out by the government. An important property is that, under
certain assumptions, it increases disproportionately with the tax rate. This result
provides the basis of a general presumption in favour of a broad-based and low tax
rate system: any exemptions which reduce the tax base inevitably raise the tax rate
required to obtain given amount of total tax revenue.
Suppose now that the government chooses the tax rates (t1… tn) on different goods
(X1, …, Xn) which have prices (p1, …, pn), in such a way as to raise a specified
revenue with the minimum total excess burden. The revenue condition is properly
seen in terms of the government’s purchasing a fixed amount of real commodities
(government spending). With fixed producer prices we can treat it as a financial
constraint expressed as:
n
R ≡ ∑ t k p k X kt = R0
k =1

where R0 is the required level of revenue2.

A solution satisfying these first-order conditions involves therefore the tax rate on
good k being in inverse proportion to the price elasticity of demand. In the extreme
case when a good demanded is completely inelastic (or a factor supplied by
households completely inelastic) the excess burden is zero and all revenue, or as
much as feasible, should be raised by taxing this commodity. Apart from this, the
optimal tax structure can be uniform only where all goods have the same elasticity of
demand. In general, the best way of raising a given revenue is by a system of taxes,
under which the rates become progressively higher as we pass from uses of very
elastic demand or supply to uses where demand or supply are progressively less
elastic.
This finding, although typically reported in public finance texts, is often regarded
with considerable skepticism. Musgrave (1959) relegates it to a footnote and
comments that the theorem is arrived at within the framework of the old welfare
economics of inter-personal utility comparison. It belongs to the welfare view of the
ability-to-pay approach. However, Musgrave’s own analysis is a special case of
that described above. Musgrave’s conclusion that a general ad valorem tax is
5
preferable to a system of selective excises imposed at differential rates assumes a
Economics of Taxation fixed supply of labour. The argument of the previous paragraph indicates that in this
case all revenue should be raised by taxing labour; and, ignoring saving, this is equivalent
to a uniform excise tax. Other writers have expressed reservations about the strength
of the assumptions. But this result may be dismissed with the comment that such
restrictive assumptions have to be made in order to derive a solution, that they
would appear to have little practical significance. However, he offers nothing in their
place.
The assumptions underlying the partial equilibrium framework are indeed restrictive,
requiring in effect that there exist no income-effects and that cross-price elasticities
are all zero.

10.4.3 Summary
According to conventional wisdom, there is a definite preference for a uniform rate
structure, but why in the indirect taxes, commodities are taxed at different rates?
This issue may be resolved on the basis of efficiency and equity grounds. Non-
desirability of uniform rates can be demonstrated by applying partial equilibrium
analysis. The situation of perfectly elastic supply as a price gets distorted when the
tax is imposed. This distortion is called as excess burden or deadweight loss or
efficiency loss. It increases disproportionately with the rate of tax and price elasticity
of demand.

Check Your Progress 1

1) What do you mean by excess burden or efficiency loss? And in which

condition(s) excess burden would be zero?
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2) Why is this called partial equilibrium analysis?
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10.5 THE RAMSEY TAX MODEL

The theory of optimal commodity taxation began with the early-twentieth-century
economist Frank Ramsey (1927), who considered the problem of a government
with a given budgetary requirement and the ability to set different tax rates for different
commodities (food, clothing, tobacco, and so on). Ramsey formulated3 the problem
of optimal taxation by asking the question: How can we raise a given amount of
revenue with the least amount of distortion? In other words, how should a government
set its tax rates across a set of commodities to minimize the deadweight loss of the
tax system while meeting its budgetary requirement? To solve this problem, he
6 formulated a model.
10.5.1 The Model Commodity Taxes

Since the initial aim is to focus on efficiency considerations, it is assumed that all
consumers are identical, and face identical tax rates, and that the objective of the
government is to maximize the welfare of a “representative” individual. On the
production side, it is assumed that there are fixed producer prices for all goods and
a fixed wage rate w for labour. Labour is to be the only factor supplied by households,
and they have no other source of income. Since the producer prices are fixed, we
can without loss of generality, set them at unity, so that the consumer price of good
k is given by (qk = 1 + tk ).
The structure of the problem is that the government is maximizing welfare subject to
the demand and supply functions of individuals, which are themselves based on
solving a constrained maximization problem. The representative consumer supplies
L units of labour (where L is measured as a fraction of the working day) and consumes
Xi of good i (i = 1, ... , n). He is assumed to maximize U(X, L) subject to the budget
constraint.
n

∑q X
t =1
i i = wL

It may be noted that there is assumed to be no tax on wage income, but if there is no
other source of income for the consumer this involves no loss of generality.
10.5.2 Equivalence Between Wage Tax And Commodity
Taxes
Now since we know the government needs to raise revenue by taxing either/or
labour (L) and commodities (X). So there is bound to be some relation between
these two tax bases4.
The government revenue remains also unaffected. A tax on wage income is therefore
equivalent in this model to a uniform tax on all goods. This depends on the fact that
there is no other source of income (such as profit income) and that we cannot tax the
consumer’s labour endowment (i.e., leisure). What is required is that the demand
functions be homogeneous of degree zero in consumer prices. The demand functions
do not have this property if the consumer receives lump-sum transfers (pays lump-
sum taxes) in nominal units, or where there are profits from the production sector.

10.5.3 Indirect Utility Function

The government aims then to maximize individual welfare subject to the revenue
constraint and the individual conditions for utility maxi-mization. The problem may
conveniently be treated in terms of the indirect utility function V(q, w). by using
Langrangean and Slutsky relation following can be derived5.

∑t S
i
i ki = −θX k or k = 1, …, n … … ([Link])

where S ik is the derivative of the compensated demand curve and

Samuelson gave the following interpretation of the equation. The left hand side is the
change in the demand for good k that would result if the consumer were compensated
to stay on the same indifference curve and the derivatives of the compensated demand
7
curves were constant. In fact, it is not possible for the latter condition to be satisfied
Economics of Taxation for all commodities, but for small taxes it is approximately true that the optimal tax
structure involves an equal proportionate movement along the compensated demand
curve for all goods (since θ is independent of k). The importance in this formula of
the compensated derivatives accords with intuition: the income-effect would arise
with any form of taxation, and the distortion stems from the substitution-effect. We
may note that multiplying ([Link]) by tk and summing gives

… … ([Link])

The left-hand side can be shown to be negative (using the negative semi-definiteness
of the Slutsky matrix), so that has the same sign as government revenue.

10.5.4 Lump Sum Tax

This is a tax not dependent on the behaviour of any taxpayer. A further interpretation
may be given for by examining the effect of allowing the government to levy a lump-
sum tax T. Welfare rises and measures the benefit expressed in terms of revenue
from being able to switch from the (optimal) indirect tax system to lump-sum taxation.
At this point we may note the consequences of relaxing the assumption of fixed
producer prices. Suppose that production takes place under constant return to scale.
The government revenue constraint is replaced by a production constraint:

wL = F ( X i ,..., X n ) + Ro … … ([Link])

where w is fixed labour is again the numeraire and the right hand side gives the
labour requirements of the∑∑ −θR0and government revenue, expressed
S ki t i =F(X),
t k sector,
private
k i
in terms of labour6.

This general formulation does not yield much in the way of concrete results. Equation
[Link] does not, for example, suggest which goods should be taxed more heavily,
and the two-good example cannot readily be extended. In order to obtain more
definite results, Ramsey himself made a number of special assumptions on the demand
side equivalent to the partial equilibrium analysis. From this it might appear that we
have to choose between definite results based on highly restrictive assumptions and
more general models yielding only limited conclusions.

10.5.5 Summary
The problem of the government is how to set its tax rates across the set of commodities
to minimize the deadweight loss of tax system while raising revenue. Ramsey solved
this riddle through a model. He hypothesized that government maximizes the welfare
of a representative individual. So in his model he assumed identical consumers,
uniform tax rate, fixed producer prices for all goods, and fixed wage rate. He
concluded that income-effect would arise with any form of taxation and the distortion
stems from the substitution-effect. In case of lump-sum tax, welfare rises. The solution
is silent on the issue of commodity-wise rate variation. The answers may be obtained
by relaxing and varying various assumptions.
Check Your Progress 2
1) What was the problem put before Ramsey?
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 ................................................................................................................... Commodity Taxes

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2) Explain the assumptions in the Ramsey model.
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10.6 PARTIAL WELFARE IMPROVEMENTS

According to Ahmed and Stern (1984), there are a number of ways to evaluate a
tax system. One is to specify a model of the economy and its initial equilibrium
together with value judgement, embodied in some social welfare function, and then
ask whether it is possible to reform taxes so as to increase social welfare. Obviously,
if we are at an optimum with respect to the social welfare function, then no improving
reform is feasible. A second approach is to ask whether there is a set of value
judgements under which, given the model of the economy, the initial state of affairs
would be deemed as optimum. That is the inverse optimum problem. The value
judgements may then be used in a number of ways. One might infer that these are
indeed the value judgements of the government and use them in appraising other
decisions. Or if the computed value judgements were seen as objectionable, then
they could be employed to criticize the existing state of affairs, in the sense that it
could be seen as optimum only with respect to disagreeable values. Thirdly, we can
seek to discover Pareto improvements in order to avoid using a, possibly
controversial, social welfare function. The literature on optimal taxation has been
criticized for directing too much attention at characterizing the optimum and not
considering the process by which it can be attained. There is a distinction between
tax design, or tax laws being written de novo on ‘a clean sheet of paper, and tax
reform, which takes as its starting point the existing tax system and the fact that
actual changes are slow and piecemeal. We now consider therefore whether we can
identify changes in tax rates that represent a partial welfare improvement in that,
although falling short of the optimum, they represent a step in the right direction.
10.6.1 Partial Welfare Improvement
As is now well known from the literature on second-best, this is a difficult area. The
question is why tax reform? The reasons may be different depending on the country.
For example, as Jha (1998) has noted:
1) There was extreme discontent with the existing tax system in most of the
countries. This took several forms. On the one hand, it was felt that, high marginal
tax rates were having serious disincentive effects on savings, labour supply and
entrepreneurship. On the other hand, they were providing considerable avenues
for tax avoidance and evasion and considerable energies and resources were
being diverted to making up tax shelters.
2) It was also felt that apart from diverting resources from work and savings to
tax avoidance, high marginal tax rates had not achieved the social and economic
9
objectives they had been designed to meet.
Economics of Taxation 3) At the same time there was concern that governments were taxing and spending
too much.
In real life it is rarely possible to reach optimal tax solutions immediately with desired
efficacy. Reforms that may appear to move in the correct direction can turn out on
closer inspection to reduce welfare. Intuition can be very misleading. Nonetheless,
the optimum tax results discussed in the previous sections provide some insights.
For this purpose, we go back to the dual formulation of Ramsey problem. In that
case we were in effect evaluating possible changes in policy in terms of their effect
on the indirect utility function7.
What happens however if we are not at the optimum? Is it possible to reach
straightforward conclusions about directions for welfare improvement? We consider
first a shift from distortionary taxation. Suppose that the government is able to raise
revenue by other means and as a result R can be reduced (dR d” 0). Does it follow
that dV > 0? The answer is not necessarily affirmative.
The negative result just described is illustrative of those in the second – best literature,
which led to a general pessimism. Some particular rules that were at one time thought
to be intuitively plausible by some economists turned out to be wrong, and this
failure received a great deal of publicity. On the other hand, this pessimism does not
seem warranted. Even though it is not true, as we have seen that any move to lump-
sum taxation is necessarily welfare-improving, there are many directions in which
tax changes may be welfare-improving. The issue is one of characterizing the
directions of feasible welfare-improving change.
In order to illustrate the possibility of constructive rather than negative second-best
results, we may note that it can be shown that under rather general conditions a
proportionate reduction in the distortion raises welfare. To see this intuitively, suppose
that all taxes are reduced proportionately with a compensating adjustment in lump-
sum taxation, T, to maintain overall revenue. If the income-effect were such that the
individual became worse off, which could only happen if T rises, this implies that the
excise revenue collected from him goes up as his level of welfare falls. If we rule out
this apparently perverse case, then the individual must be better off.
Another example of a “constructive” second-best result is the following. In the context
of a simple model, with two consumption goods and labour, the latter being the
untaxed numeraire, they show that, subject to one qualification, beginning with an
initial situation of uniform taxes, welfare can be increased by raising the tax on the
good “more complementary” with leisure, while lowering the other tax so that revenue
is unchanged.
The relation between optimal taxation and tax reform can be considered further. For
a number of reasons policy-makers may be unwilling, or unable, to make large
changes in the tax structure. The reasons include the fact that our knowledge of the
relevant production and demand parameters is typically limited to the neighbourhood
of the current position, and even here there may be considerable uncertainty.
(A factor working in the opposite direction is that there are fixed costs to tax reform
– which would point to infrequent changes.) In view of this, in a number of ways the
problem may be characterized as one of choosing from neighbouring equilibria - or
of designing the optimal tax change subject to a constraint on their overall magnitude.
This raises the question of the process of tax reform, where there is a clear parallel
10 with the literature on planning algorithms. At each point we need to ask whether
there is a feasible, welfare-improving step which can be made; and we need to ask Commodity Taxes
whether the sequence of “tax reforms” converges and, if so, what are the
characteristics of the limiting solution. Among the general features of their results are
the difficulties posed by the basic non-convexity of the set of equilibria (already
discussed in Ramsey problem) and the demonstration that inefficiency in the
production sector may be necessary temporarily in the process of tax reform. If the
process of tax reform is subject to a constraint of the kind described, and is required
to be welfare-improving, then the condition of production efficiency that characterizes
the full optimum may not apply on the route to the optimum.

10.6.2 Horizontal Equity

It is possible that the government may not achieve re-distributive goal by maximizing
the social welfare function. In this case horizontal inequity is not ruled out. This is
also one of the Ramsey tax problems. It may be possible to raise social welfare by
taxing identical individuals at different rates. It is for this reason that the specification
of the problem in terms of each individual facing identical tax rates is an assumption,
not an implication of welfare maximization8. On the other hand, it may not be an
unreasonable assumption. But, the most appealing interpretation of horizontal equity
may be that it imposes certain prior constraints on the instruments, which the
government can employ. The constraint that all individuals face the same rates of
indirect tax may well appear reasonable in this context, and thus provide a justification
for this assumption.
The introduction of differences in tastes makes the problem even more severe. This
is because the social welfare function approach evaluates taxes in terms of the
individual’s ability to derive utility from goods and leisure, in contrast to the criterion
of “ability to pay”, which bases taxation on opportunity sets. When the only
differences are those in ability to produce, then maximizing social welfare function
leads to redistribution from those with “better” to those with “poorer” sets. There is
no conflict between it and the ability-to-pay approach. But this may arise as soon as
tastes differ. Suppose individual 1 has a higher productivity, so that his budget
constraint lies outside that of individual 2. The ability to pay criterion would indicate
that individual 1 paid more tax, but there are obviously numberings of their
indifference curves, which lead to the opposite result with the social welfare function9.
Suppose that the government were to adopt this version of horizontal equity; what
would be the implications for the optimal tax structure? It is popularly believed that
it would require uniform taxation. If two individuals are identical in all respects except
that one likes chocolate ice cream and the other likes vanilla, a system that taxes
chocolate ice cream at a higher rate is felt to be horizontally inequitable. This is not
however necessarily correct. Horizontal equity does not imply uniform taxation where
the elasticity of demand differs between the goods in question. The horizontal equity
implies in fact the elasticity of demand for a good, and the taste differences affecting
the consumption of goods only. The condition for horizontal equity is not necessarily,
therefore, uniform taxation; only if the price elasticity is the same – as of course it
may be in the chocolate-vanilla ice cream case – would uniform tax rates be
horizontally equitable.

10.6.3 Tax Reform

Tax reform is the process of changing the way taxes are collected or managed by
the government. Tax reformers have different goals. Some seek to reduce the level 11
Economics of Taxation of taxation of all people by the government. Others seek to make the tax system
more/less progressive in its effect. Still others may be trying to make the tax system
more understandable, or more accountable. Many organizations have been setup to
reform tax systems worldwide, often with the intent to reform Income Taxes or
Value Added Taxes or Property Taxes into something considered more economically
liberal. Others propose tax systems that attempt to deal with externalities. Various
tax proposals have been presented. Among these have been the Flat Tax, Fair Tax,
Value Added Tax, and many others.
There are widely recognized indicators of good tax policy to analyze proposed
changes.
These ten guiding principles are equally important, and should be considered both
separately and together when evaluating the current system and reform proposals.
Simplicity: The tax law should be simple so that taxpayers understand the rules and
can comply with them correctly and in a cost-efficient manner.
Fairness: Similarly situated taxpayers should be taxed similarly.
Economic Growth and Efficiency: The tax system should not impede or reduce
the productive capacity of the economy.
Neutrality: The effect of the tax law on a taxpayer’s decisions as to how to carry
out a particular transaction or whether to engage in a transaction should be kept to
a minimum.
Transparency: Taxpayers should know that a tax exists and how and when it is
imposed upon them and others.
Minimizing Noncompliance: A tax should be structured to minimize noncompliance.
Cost-Effective Collection: The costs to collect a tax should be kept to a minimum
for both the government and taxpayers.
Impact on Government Revenues: The tax system should enable the government
to determine how much tax revenue will likely be collected and when.
Certainty: The tax rules should clearly specify when the tax is to be paid, how it is
to be paid, and how the amount to be paid is to be determined.
Payment Convenience: A tax should be due at a time or in a manner that is most
likely to be convenient for the taxpayer.

10.6.4 Summary
Analysis of partial welfare improvement shows that intuitively attempted reform can
turn out to reduce welfare. The involved solution could not achieve an increase in
welfare. Theoretically it may be proved that how a move towards lump-sum taxes
from the distortionary tax optimum raises welfare. But this is not the case everywhere.
It has been shown that under rather general conditions a proportionate reduction in
the distortion raises welfare. Horizontal equity is desirable given the tastes and ability
to pay varies. Tax reform is the process of changing the way taxes are collected or
managed by the government. Various tax proposals have been presented. Among
these have been the Flat Tax, Fair Tax, Value Added Tax, and many others.

12
Check Your Progress 3 Commodity Taxes

1) How a tax system can be evaluated?

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2) Describe concept of horizontal equity in your words. How can you differentiate
a uniform taxation with differential tax structure?
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
3) Why tax reforms are desirable?
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................

10.7 LET US SUM UP

In this unit we have tried to discuss that one of the main functions of the second-best
literature show that certain common preconceptions about the desirable policy
changes are not necessarily correct, and that intuitive arguments based on first-best
considerations may be misleading. This is well illustrated by the arguments for a
uniform structure of indirect taxation. As we have seen, neither the efficiency argument
is far from convincing; nor does horizontal equity necessarily imply a general sales
tax.
These counter examples to conventional wisdom have led to a degree of pessimism
about second-best tax policy. This is however unwarranted in the sense that, starting
from an arbitrary initial tax structure, there is likely to be a large number of tax
reforms that potentially raise welfare. Moreover, it is possible to obtain some insight
into the role of different factors, particularly efficiency and equity considerations. At
the same time, the characterization of an optimal tax structure, and of the process by
which the process by which it can be attained, requires detailed investigation of the
appropriate model. There are not typically simple rules with wide applicability.

10.8 KEY WORDS

Consumer Surplus : A consumer’s surplus is the excess of the
price which a person would be willing to pay
rather than go without an article, over that
which he actually does pays it may be called 13
Economics of Taxation Consumer’s Rent. The consumer surplus is
measured by the area under the demand curve
which represents the additional aggregate
payment consumers would pay at the going
price. A perfectly discriminating monopolist
leaves no surplus.
Compensated Demand Curve : The Compensated Demand Curve (CDC)
shows how the substitution effect influences
the number of units of a good the consumer
will purchase. A CDC shows how the number
of units of a good purchased at a given price
changes as the price changes, assuming the
consumer’s income is increased enough to
offset the income effect.
Deadweight Loss : A deadweight loss (also known as excess
burden) is a loss of economic efficiency that
can occur when equilibrium for a good or
service is not Pareto optimal. In other words,
either people who would have more marginal
benefit than marginal cost are not buying the
good or service or people who would have
more marginal cost than marginal benefit are
buying the product. Causes of deadweight
loss include monopoly pricing, externalities or
taxes or subsidies.
Effective Tax Rates : Tax rates an individual actually pays.
Elasticity of Demand : The per centage change in the quantity
demanded of a good caused by each one
per cent change in the price of that good.
Equity-Efficiency Trade-Off : The choice society must make between the
total size of the economic pie and its
distribution among individuals.
Excess Burden : It is the additional cost of raising given revenue
through distortionary taxation rather than
through a poll tax yielding equal revenue.
Income-Effect : A rise in the price of a good will typically
causes an individual to choose less of all goods
because his income can purchase less than
before.
Indirect Utility Function : A consumer’s indirect utility function v(p,w)
gives the consumer’s utility when faced with
a price level p and an amount of income w. It
represents the consumer’s preferences over
market conditions.
This function is called indirect because
14 consumers usually think about their
 preferences in terms of what they consume Commodity Taxes
rather than prices. A consumer’s indirect utility
v(p,w) can be computed from its utility
function u(x) by first computing the most
preferred bundle x(p,w) by solving the utility
maximization problem; and second,
computing the utility u(x(p,w)) the consumer
derives from that bundle. The indirect utility
function for consumers is analogous to the
profit function for firms.
Formally, the indirect utility function is:
– Non-increasing in prices, because an
increase in prices cannot open up an
available bundle that would provide more
utility;
– Non-decreasing in income, because when
income rises, at worst you could consume
the same bundle;
– Homogenous with degree zero in prices
and income; if prices and income are all
multiplied by a given constant the same
bundle of consumption represents a
maximum, so optimal utility does not
change.
This gives a method of deriving the
Marshallian demand function of a good for
some consumer from the indirect utility
function of that consumer. It is also
fundamental in deriving the Slutsky equation.
Lump-Sum Tax : It is a tax that does not depend on the
taxpayer’s behaviour, i.e., a fixed taxation
amount independent of a person’s income,
consumption of goods and services, or
wealth. It has no excess burden.
Marginal Deadweight Loss : The increase in deadweight loss per unit
increase in the tax.
Marginal Tax Rate : The per centage that is paid in taxes of the
next rupee earned.
Numeraire : The numeraire is the money unit of measure
within an abstract macroeconomic model in
which there is no actual money or currency.
A standard use is to define one unit of some
kind of goods output as the money unit of
measure for wages. For example, a good for
which the price is set at Re. 1 in order to model
choice between goods, which depends on
15
relative, not absolute, prices.
Economics of Taxation Optimal Commodity Taxation : Choosing the tax rates across goods to
minimize deadweight loss for a given
government revenue requirement.
Partial Equilibrium Analysis : Partial equilibrium analysis means that the
effects of policy actions are examined only in
the markets which are directly affected.
Supply and demand curves are used to depict
the price effects of policies. Producer and
consumer surplus is used to measure the
welfare effects on participants in the market.
A partial equilibrium analysis either ignores
effects in other industries in the economy or
assumes that the sector in question is very very
small and therefore has little if any impact on
other sectors of the economy.
Poll Tax : A poll tax, soul tax, or capitation is a tax of a
uniform, fixed amount per individual (as
opposed to a per centage of income). Such
taxes were important sources of revenue for
many countries into the 19th century, but this
is no longer the case. The word poll is an
English word that once meant “head”, hence
the name poll tax for a per-person tax.
However, in the United States, the term has
come to be used almost exclusively for a fixed
tax applied to voting.
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.
Sales Taxes : Taxes paid by consumers to vendors at the
point of sale.
Statutory Tax Rates : Tax rates laid out in the legal tax schedule.
Substitution-effect : Every price change can be decomposed into
an income effect and a substitution effect. The
substitution effect is a price change that
changes the slope of the budget constraint,
but leaves the consumer on the same
indifference curve. This effect will always
cause the consumer to substitute away from
the good that is becoming comparatively more
expensive. If the good in question is a normal
good, then the income effect will re-enforce
the substitution effect. If the good is inferior,
then the income effect will lessen the
16
 substitution effect. If the income effect is Commodity Taxes
opposite and stronger than the substitution
effect, the consumer will buy more of the good
when it becomes more expensive. An
example of this might be a Giffen good.
Tax Evasion : Illegal nonpayment of taxation.
Tax Incidence : Assessing which party (consumers or
producers) bear the true burden of tax.
Tax Shelters : They are any method of reducing taxable
income resulting in a reduction of the payments
to tax collecting entities, including state and
federal governments. The methodology can
vary depending on local and international tax
laws. These tax shelters are usually created
by the government to promote a certain
desirable behaviour, usually a long term
investment, to help the economy; in turn, this
generates even more tax revenue.
Alternatively, the shelters may be a means to
promote social behaviours. In Canada, in
order to protect the “Canadian culture” from
American influence, tax incentives were given
to companies that produced Canadian
television programs. In general, a tax shelter
is any organized program in which many
individuals, rich or poor, participate to reduce
their taxes due. However, a few individuals
stretch the limits of legal interpretation of the
income tax laws. While these actions may be
within the boundary of legally accepted
practice in physical form, these actions could
be deemed to be conducted in bad faith. Tax
shelters were intended to induce good
behaviours from the masses, but at the same
time caused a handful to act in the opposite
manner. Tax shelters have therefore often
shared an unsavory association with fraud.
Value Added Tax (VAT) : A consumption tax levied on each stage of a
good’s production on the increase in value of
the good at that stage of production.

10.9 SOME USEFUL BOOKS

Ahmed, A and NH Stern (1984): “The Theory of Reform and Indian Indirect
Taxes.” Journal of Public Economics, 25, 259-298.
Atkinson, AB (1980): Public Economics. London: McGraw-Hill Book Co (UK)
Ltd.
Feldstein, M (1976): “On the Theory of Tax Reform”. Journal of Public Economics.
17
July-August (International Seminar in Public Economics and Tax Theory).
Economics of Taxation Jha, R (1998): Modern Public Economics. London and New York: Routledge.
Musgrave, RA (1959): The Theory of Public Finance. New York: McGraw-Hill.
Musgrave, RA and PB Musgrave (1989): Public Finance in Theory and Practice,
V Ed. New York: McGraw-Hill.
Prest, AR (1975): Public Finance in Theory and Practice, V ed. London:
Weidenfeld and Nicolson.
Ramsey, FP (1927): “A Contribution to the Theory of Taxation”, Economic
Journal, March.
Stiglitz, JE (2000): Economics of the Public Sector, III Ed. London: W.W. Norton
& Company.
Tresch, RW (2002): Public Finance: A Normative Theory. London: Academic
Press. II Ed.

10.10 ANSWERS/HINTS TO CHECK YOUR

PROGRESS
Check Your Progress 1
1) The definition may be searched from the section just discussed. For the second
part of the question, use the diagram to find out the answer. The demand curve
may be rotated to reach a level where excess burden would be zero.
2) It may be observed that the foregoing analysis is not complete. It takes into
account only a few conditions. You may visualize other conditions also to
complicate the model and new results may be obtained.
Check Your Progress 2
1) In the section, the problem is given for which Ramsey gave the solution.
2) The assumptions of the Ramsey model are clearly given. With your imagination
you may try to justify how far these assumptions may include more.
Check Your Progress 3
1) Various ways of evaluating tax system are given in this section. You may try to
think more of them.
2) See section 10.6.2
3) See section 10.6.3

10.11 EXERCISES
1) Using different price elasticity of demand show the excess burden would be
different.
2) Using different tax rates show how the deadweight loss would vary.
3) Give rationale for and against uniform rate v/s multiple rate tax structure.
4) Give rationale for multi-rated sales tax system v/s single rated VAT.
5) On the basis of optimal taxation justify tax reforms.

18
 Commodity Taxes
End Notes
Technical Annexure to the Lecture
Those students, who are interested to follow further rigours, may join this annexure
with the main material. This is related with the sections as numbered. The connecting
numbers are also provided for help.
1
Let us denote the consumer price by qk and write the demand curve as qk(Xk).
The excess burden caused by the tax on good k may then be seen from Figure
1 to equal:
X ko
Bk ≡ ∫ t q k dX k − p k ( X k0 − X kt ) … … ([Link])
X k

where X k0 denotes the equilibrium quantity before the tax is introduced, X kt

that after the tax is introduced. From this it follows that

∂Bk ∂X kt ∂X kt ∂X kt
= −q k + pk = − pk t k … … ([Link])
∂t k ∂t k ∂t k ∂t k

where the term in qk arises from differentiating the lower limit of integration and
the second step follows from the fact that qk = pk(1+tk).
2
This constrained maximization problem may be formulated in terms of the
Lagrangean (V):
n ε kd
ς = −∑ Bk +λ ( R − R0 ) … … ([Link])
k =1

The first-order conditions for the choice of tk are therefore

∂Bk ∂R ∂X kt
=λ = λp k X kt + λp k t k for all k … … ([Link])
∂t k ∂t k ∂t k

Combining this with Equation [Link], we obtain

− t k ∂X kt λ
= … … ([Link])
X k ∂t k
t
1+ λ

or

tk θ
= d … … ([Link])
1 + tk ε k

{This step may be seen if we rewrite the left-hand side as

⎛ tk ⎞ ⎡ p k (1+tk ) ⎤ ⎡ ∂X kt ⎤
⎜⎜ ⎟⎟ ⎢ ⎥ ⎢− ⎥
⎝ 1 + tk ⎠ ⎣ X k ⎦ ⎣ ∂p k (1 + t k ) ⎦
t

which equals t k / (1 + t k ) times the elasticity of demand. }

where è is equal to λ /(1 + λ ) and is the elasticity of demand for good k.

19
Economics of Taxation 3
Ramsey’s theorem is a generalization of Dilworth’s lemma which states for
each pair of positive integers and there exists an integer (known as
the Ramsey number) such that any graph with nodes contains a clique with at
least nodes or an independent set with at least nodes.
Another statement of the theorem is that for integers k , l ≥ 2 , there exists a
least positive integer R (k, l) such that no matter how the complete graph is
KR(k, l) two-colored, it will contain a green sub-graph Kk or a red sub-graph Kl.
A third statement of the theorem states that for all k ∈ N , there exists an l ∈ N
such that any complete digraph on graph vertices contains a complete transitive
sub-graph of k graph vertices.
For example, R (3, 3) = 6 and R (4, 4) = 18, but R (5, 5) are only known to
lie in the ranges 43 ≤ R (5, 5) ≤ 49 and 102 ≤ R (6, 6) ≤ 165.
It is true that
R ( k , l ) ≤ R ( k − 1, l ) + R ( k , l − 1)
if k , l ≥ 3
4
Assume to maximize U(X, L) subject to the budget constraint
n

∑q X
t =1
i i = wL … … ([Link])

Suppose that a tax of τ is imposed on wage income. The consumer’s budget

constraint becomes
ςt'∑
i =qV
iX(qi , =w)w+(1λ−(τ∑
) Lt i X i − R0 )
i … … ([Link])i

(the summation runs from 1 to n unless otherwise indicated). As far as the

consumer is concerned, this is equivalent to a situation where there is no wage
tax and qi is increased to q/(1-τ); i.e., for the tax rate to become effective rate
for the ith commodity:

1 + ti τ + ti
t 'i = −1 = … … ([Link])
1−τ 1−τ
The government revenue in the latter case is

⎛ τ + ti ⎞
∑ t'
i
i X i = ∑⎜
⎝ 1−τ ⎠
⎟ X i … … ([Link])

which may be compared with that in the case of the wae tax. With both types
of taxes,

τ ⎛ τ + ti ⎞
∑t X
i
i i + τwL = ∑ t i X i +
i 1−τ
∑ (1 + t ) X
i
i i = ∑⎜
i ⎝ 1−τ ⎠
⎟X i … … ([Link])

where we have substituted for wL from Equation ([Link]).

5
Forming the Lagrangean ( ς ):

… … ([Link])
20
 gives first-order conditions for the tax rate tk Commodity Taxes

∂V ⎛ ∂X i ⎞
= −λ ⎜⎜ X k + ∑ t i ⎟
∂q k ⎝ i ∂q k ⎟⎠ for k = 1, … , n … … ([Link])

Writing α for the marinal utility of income to the consumer, and using the
properties of the indirect utility function ,

∂X i (λ − α ) X
∑t
i
i
∂q k
=−
λ
k for k = 1, …, n … … ([Link])

These equations may be transformed using the Slutsky relationship

∂X i ∂X i
= S ik − X k for all i, k … … ([Link])
∂q k ∂M

where S ik is the derivative of the compensated demand curve and ∂X i / ∂M

denotes the income-effect (evaluated at M (after tax other income) = 0).
Substituting, we obtain
⎛ ∂X i α ⎞
∑t S
i
i ik = −⎜1 − ∑ t i
⎝ i ∂M
− ⎟X k
λ⎠
for k = 1, …, n … … ([Link])

Using the symmetry of the Slutsky terms ( S ik = S ki ) , and introducing θ for the
coefficient of in ([Link]),

∑t S i ki = −θX k for k = 1, …, n … … ([Link])

ςVςV
∂(d∂X∂ /=
∂/t ∂
dVq=⎛ 0==∂⎛Lλθ
−αdT
X )∂∂XX ⎞⎞
i = −kα
k=
∂qTk ⎜ ∂q ∑
∑
λ ⎜+kwλ ⎜1 −− tkF i i ⎟⎟ = θλ
i i
q k ⎠⎟⎠
∂∂M
⎝ ⎝k ii
From this expression, one can see the relation with the partial equilibrium formula
([Link]). If there are no income-effects (∂X i / ∂M = o) , and if =0 for, then
Equation ([Link]) becomes tk(–Skk) = θXk.
6
The Lagrangean then becomes

ς = V (q, T ) + λ (T + ∑ t i X i − R0 ) … … ([Link])
i

From this we can see that, using the definition of θ ,

… … ([Link])

(Since ∂V / ∂T = −α and ∂X i / ∂T = −∂X i / ∂M ). Now suppose that the

government were allowed to make a small increase dT in the lump-sum tax
(moving away from the optimum described above), where the commodity
taxes are adjusted so that the revenue constraint continues to hold. Then
dς / dT = ∂ς / ∂T (since for all k from the first-order conditions)
and, since the revenue constraint continues to hold, .
The first-order conditions become

… … ([Link])
21
Economics of Taxation Since there are constant returns to scale, there is no pure profit income, so that
differentiating the consumer’s budget constraint yields
w∂L ∂X i
= X k + ∑ qi … … ([Link])
∂q k i ∂q k

Profit maximization in the private sector implies Fi = pI, where pI are producer
prices (the private sector maximizes ∑ pi X i − F ( X 1 ,..., X n ). ), so it follows
that

… … ([Link])

(noting that qi – pi = ti). We are therefore back with first order condition
([Link]). The form of the first-order conditions is therefore unaffected in the
case of constant returns to scale, on the other hand, the producers prices in
general vary with changes in the tax rates.
7
If we denote a possible variation in tax rates by the vector dt, then, by the
properties of the indirect utility function,
dV = −αX '.dt … … ([Link])
The effect of this variation on the revenue is
… … ([Link])
The solution involves identifying conditions under which variations satisfying
(3.2) could not achieve an increase in welfare.

∑
α∂tV'=
dt
dR
dV (Sdt )α
Δ−t−(i'.=
==
If the proportionate reduction qdX
2X
≤α'+pdt
⎛−is db( −'.>α
1t)'Xdb
Stdb
= −λ ⎜⎜ X k + ∑ t i
=0),
dt −∂tdb
dT
⎟
Xi ⎞
then
∂iq k … … ⎝ ([Link])
i ∂t k ⎟⎠

The change in lump-sum tax is

dT = −t ' dX − X ' dt … … ([Link])
The change in welfare is
… … ([Link])
= αt' dX
(using (3.4)). Now the change in demands consists of a substitution term and
an income term. The substitution component is given by
… … ([Link])
where S is the Slutsky matrix. From the negative semi-definiteness of S, it
follows that this component is non-negative.
Geometrically, the effect is that a move in the direction PB raises welfare
(the origin being drawn at t1 = t2 = 0).
For example,

… … (10.6.1.7a)

and

∑ i
Δt i ≤ 1 … … (10.6.1.7b)
22
8 Commodity Taxes
Let us consider the redistributive goals of the government by maximizing a
social welfare function Ø(Vi , … , Vh). Horizontal inequity is not ruled out by
the maximization of this social welfare function. This is a further referred to in
Ramsey tax problem, and it may be possible to raise social welfare by taxing
identical individuals at different rates.
9
In order to illustrate the relationship between these objectives, let us suppose
that tastes may be represented by a single parameter γ , so that the indirect
utility function may be written as . The social welfare function
approach recognizes such taste differences as a legitimate basis for discrimination,
and the government maximizes Ø (V (q, w, γ )) . On the other hand, if we introduce
the concept of horizontal equity and interpret this as meaning that difference in
tastes are not “relevant” characteristics for discrimination, then these has two
implications. First, it introduces a cardinalization, V (q, w, γ ) = V ( p, w) , so that
only endowments (w) and consumer prices (normalized at before-tax levels)
are relevant. Second, it constrains the government in levying taxes (q ≠ p ) to
maintain

V (q, w, γ ) = V (q, w) … … ([Link])

Suppose that the government were to adopt this version of horizontal equity;
what would be the implications for the optimal tax structure? It is popularly
believed that it would require uniform taxation. If two individuals are identical
in all respects except that one likes chocolate ice cream and the other likes
vanilla, a system that taxes chocolate ice cream at a higher rate is felt to be
horizontally inequitable. This is not however necessarily correct. Horizontal
V (q, w, γ )
equity does not imply uniform taxation where the elasticity of demand differs
between the goods in question. The horizontal equity condition ([Link])
implies in fact

q11−ε1 = q12−ε 2 … … ([Link])

where å1 denotes the (constant) elasticity of demand for good i, and the taste
differences are multiplicative (affecting X1 and X2 only). The condition for
horizontal equity is not necessarily, therefore, uniform taxation; only if the price
elasticity is the same – as of course it may be in the chocolate-vanilla ice cream
case – would uniform tax rates be horizontally equitable.
Finally, we may note that this example also brings out the conflict between
horizontal equity and maximization of a social welfare function. The condition
([Link]) is not in general consistent with the maximization of Ø(V). On the
other hand, on the interpretation of horizontal equity as a constraint on instruments
– what we have identified as the “means”, rather than “ends”, approach – there
is no necessary conflict. The horizontal equity criterion is logically prior, imposing
constraints on the choice of tax policy. On this basis, discrimination against
chocolate ice cream lovers would be ruled out a priori.

23