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Public Sector Economics
Optimal Taxation
Optimal Taxation in the Logic of Public Finance
• first determine how policy affects the economy
(dwl, winners and losers)
• examples of duality, mechanism design
[closely related to I-O optimal pricing questions]
• a positive theory of government
• Optimal tax topics
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–
–
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inverse elasticity principle
tax reform
screening
taxation in-kind
Deadweight Costs
• resource and/or efficiency loss from tax evasion
and avoidance
• derives from the microeconomic involuntary
nature of tax payments
– taxpayers change their behavior to reduce their tax bill
– beneficiaries change their behavior to increase their
benefit
– the behavioral change is often costly to the
taxpayer/beneficiary and to the treasury
– like melting ice: $1 in taxes cost taxpayers more than
$1, and help beneficiaries less than $1
• there is no close analogue in the private sector
• higher tax rates lead to higher deadweight costs,
and at an increasing rate
Narrow tax base
north dwc
south dwc
average dwc
20%
north
tax rate
0%
south
tax rate
Broad tax base
north dwc
south dwc
average dwc
10%
north
tax rate
10%
south
tax rate
Narrow tax base
north dwc
south dwc
average dwc
20%
north
tax rate
0%
south
tax rate
A Tax Collection Principle
Minimize dwc of taxes per dollar of revenue,
eg., with low rates and broad base
• not a trivial issue in practice. Consider
three federal taxes, 1994:
– personal income tax: $543b with typical rate of
24%
– payroll tax: $484b with rate of 12%
– corporate tax: $140b with rate of 35%
• basic principle behind “The Flat Tax”
DWCs: Summary
• in the corporate sector, creditors are (individually)
voluntary participants
• government revenues are provided by (individually)
involuntary participants  deadweight costs
• hence, principles of public and corporate finance are
different
• deadweight costs may be reduced when government is
“widely held” – aka, tax base breadth
Tax Reform Jargon
• revenue neutral
• CBIT = clean-base income tax
• x tax
– graduated rates on labor income without deductions
• flat tax
– single rate (or few rates)
– on labor income
– without deductions
• cash flow tax – a direct consumption tax (can be
graduated)
• R-base tax: income tax with investment deductions
• sales tax
• VAT = value-added tax
Optimal Screening
• Favored group membership is like an occupation
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–
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e.g., poor,
elderly,
farmers,
persons with American Indian ancestors, etc.
• free entry into a favored group is inconsistent
with policies that raise their utility
– in the absence of natural entry barriers, lump sum transfers are
not optimal
– in-kind and other distortionary subsidies create deadweight
losses, but may raise entry barriers
• literature
– Stigler (1971) on occupational licensing
– Becker (1983) and Gardner (1983) on farm subsidies
– Nichols and Zeckhauser on “socially optimal screening”
• some distortionary subsidies lower barriers