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PUBLIC
Holcombe
FINANCE
/ THE
REVIEW
RAMSEY RULE RECONSIDERED
The Ramsey rule for optimal excise taxation suggests that goods should be taxed in inverse proportion to their elasticities of demand. This analysis shows that when the political process that determines tax rates is taken into account, the Ramsey rule may not be
superior to a fiscal constitution that specifies that all goods are taxed at the same rate.
The information necessary to set taxes in conformance with the Ramsey rule is not directly observable, which will lead to rent-seeking activities as interest groups try to influence the political determination of tax rates they face. Furthermore, incentives in the political process work against setting taxes according to the Ramsey rule. Building on
Buchanans work on optimal taxation and the nature of the fiscal constitution, the
Ramsey rule should be reconsidered as a guide to optimal excise tax policy.
562
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(1967, 1975, 1976) idea that the tax structure should be embodied in a
relatively inflexible fiscal constitution, and such a fiscal constitution
would have no room for concepts like the Ramsey rule, which imply
flexibility in tax policy.
Because in its simplest form, the Ramsey rule advocates setting excise tax rates for goods in inverse proportion to their elasticities of demand, if a legislature wants to apply the Ramsey rule, at a minimum it
would have to know the demand elasticities of the taxed goods. Herein
lies the first problem. Demand elasticities are not directly observable.
The market directly generates price data, so if a legislature wanted to
know the prices of goods, it could observe them directly; however, to
find the demand elasticities of goods, it would have to somehow obtain estimates. In a democratic government, the process of obtaining
such information is a political process in which interest groups involve
themselves to try to generate outcomes that favor those groups. Each
interest group has an incentive to hire experts who provide the legislature with information showing that their goods have very elastic demands and so should have low taxes, whereas the goods of other sellers are very inelastic. Other interests do the same, so the legislature
will be presented with conflicting information from interest groups
that are trying to minimize their own tax burdens. Because there is no
way to directly observe the information the legislature needs to implement the Ramsey rule, the demand elasticities it uses are more likely to
reflect the political strengths of various interest groups than the actual
elasticities of demand for the taxed goods. One might argue, following
Becker (1983) and Wittman (1989), that the political process will generate accurate information about demand elasticities, but the model
presented below casts doubt on this idea.
Before public choice, public finance typically assumed that public
policy was made by an omniscient and benevolent government that always implemented policy according to the welfare-maximizing policy of the economic model being employed. If the assumption of be-
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564
The information problem is worse than the previous section indicates because the Ramsey rule is derived in a static model, but in the
real world, demand elasticities change over time. Implementing the
Ramsey rule is not simply a matter of estimating demand elasticities
and setting tax rates in inverse proportion to them in perpetuity. If the
excise tax structure is designed to minimize the excess burden of taxation, excise tax rates must continually be adjusted to reflect changes in
the underlying economic data. This further opens the process to political manipulation. Interest groups cannot simply present their best
cases and then pay whatever taxes the political system throws their
way. Rather, there is the continuing incentive for interest groups to go
back to the legislature to argue that demand for their goods is more
elastic now than it was when the tax structure was last adjusted, and
other goods have more inelastic demands, so their taxes should be
lowered and taxes on others should be raised. In a static model, the
Ramsey rule implies a particular tax rate for each good, but in the dynamic real world, the Ramsey rule implies a continual readjustment of
tax rates to reflect continual changes in demand elasticities.
Implementation of the Ramsey rule implies a flexible structure of
excise tax rates to reflect changes in demand elasticities, and a flexible
tax structure gives interest groups the incentive for continual rent
seeking. Thus, following McChesney (1987, 1997), taxpayers and potential taxpayers must continually engage in lobbying activities, with
all the associated rent-seeking losses, to prevent themselves from being taxed more heavily in the future. Potential taxpayers who drop out
of the political process will find themselves easy targets when excise
tax rates are readjusted to reflect any changes in the governments esti-
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565
mated elasticities of demands. Because the tax system must be flexible to adapt to changes in the underlying demand elasticities, attempting to keep tax rates in conformity with the Ramsey rule will produce
continual rent-seeking losses.
When one considers the political environment within which excise
taxes are determined, if the legislature has as its goal designing a set of
excise taxes to conform with the Ramsey rule, it will not be able to
achieve that goal because the information to do so will be unavailable
to it. In the process of trying, it will encourage constant rent seeking
along with its associated costs. Because the tax structure must always
be subject to change to maintain tax rates implied by the Ramsey rule,
this encourages substantially more rent seeking than if tax rates were
set within a relatively inflexible fiscal constitution. If one includes all
costs associated with the tax system, including the excess burden and
political and rent-seeking costs, then when the political environment
within which taxes are created is taken into account, the welfare cost
of commodity taxation is likely to be lower, with fixed and uniform
rates set in a fiscal constitution instead of trying to satisfy the Ramsey
rule. The model developed below illustrates why this is the case.
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POLITICAL INCENTIVES
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tively inelastic demand DI, such that with no taxes, both goods have
perfectly elastic supply curve S and market equilibrium prices and
quantities P* and Q*. If all demand and supply curves are straight
lines and supply is perfectly elastic, the Ramsey rule is implemented
by levying tax (P1 P *) on the good with the more elastic demand
and (P2 P *) on the good with the more inelastic demand, so that after the tax, the good with DI sells for P2 and the good with DE sells for
P1 . Both goods see an identical percentage decline in their quantity exchanged, from Q* to Q. To see that this is so, note that representing
the total tax revenue from the excise tax as TR, the tax revenue for any
good, i, meeting the above conditions is
TR = ( Pi P*) Q,
(1)
(2)
Dividing (2) by (1), simplifying gives the excess burden as a fraction of total tax revenues collected:
EB TR = (Q* Q)2Q.
(3)
Under the above assumptions, the ratio of the excess burden to total
tax revenues is a function of the reduction in the quantity exchanged
only and is not dependent on the tax rates or prices, which differ depending on the demand elasticities. Thus, for the assumptions above
(perfectly elastic supply curves; linear demand curves), the Ramsey
rule is satisfied when the excise taxes cause the same percentage decline in the quantity exchanged for all goods.
The application of the Ramsey rule imposes larger costs on markets
with more inelastic demands both because those markets have higher
tax burdens imposed and because the excess burdens, which are proportional to their taxes, are higher. If the Ramsey rule is imposed, this
gives groups with more inelastic demands a greater incentive to engage in rent-seeking costs to try to lower their taxes than groups with
elastic demands, which have to fight against higher taxes. In the twogood case represented in Figure 1, assume that with taxes conforming
to the Ramsey rule imposed, those trading in the market with DI go to
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569
P2
P1
P*
DE
DI
Q1
Q Q2 Q*
the legislature and argue that they really have the more elastic demand,
and rather than their paying tax P2 P * with tax P1 P * on the other
good, those taxes should really be reversed. If they could get their tax
lowered from P2 P * to P1 P *, their gain would be
GI = ( P2 P1 ) Q+ 1 2 ( P2 P1 ) (Q2 Q ),
(4)
where the term before the plus sign equals the gain from the lower
taxes imposed on the group, and the term after the plus sign represents
the gain from the lower excess burden. Equation (4) simplifies to
GI = 1 2 ( P2 P1 ) ( 3Q2 Q ).
(4)
Similarly, if the group trading in the more elastic good had its tax
raised to the level the Ramsey rule specifies for the less elastic good,
its loss would be
GE = ( P2 P1 ) Q1 + 1 2 ( P2 P ) (Q Q1 ),
(5)
where, as above, the term before the plus sign equals the increased
taxes it has to pay, and the term after the plus sign equals the increase
in that groups excess burden. Simplifying Equation (5) yields
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570
GE = 1 2 ( P2 P1 ) (Q1 + Q ).
(5)
One can see that Equation (4) is larger than Equation (5) because
both share the common elements 1 2 (P2 P1 ), and dropping both from
each, one can see that
Q1 + Q < 2Q < 3Q2 Q.
(6)
Thus, the group with the inelastic demand and facing the higher taxes
under the Ramsey rule has a greater incentive to lobby for lower taxes
than the group with the elastic demand, which has to lobby against
higher taxes. This unequal political pressure pushes toward more uniformity in excise tax rates and away from the tax rates specified by the
Ramsey rule.
The simple model in the previous section shows that even if an excise tax structure begins in conformance with the Ramsey rule, political forces work to create an excise tax structure with more uniform excise tax rates than the Ramsey rule implies. Common sense accords
with this result. Groups that have higher costs imposed on them by the
tax system have a greater incentive to incur political costs to change
the system than groups that have lower costs imposed on them. The
Ramsey rule, by design, imposes higher costs on inelastically demanded goods than those with more elastic demands, giving those
who trade in the more inelastic markets a greater incentive to incur political costs to get their taxes lowered. Because those in markets with
more inelastically demanded goods have a greater incentive to incur
political costs to lower their taxes, political pressures will tend to reduce their taxes relative to those in markets with more elastic demand,
pushing the excise tax system away from conformation with the
Ramsey rule.
Even a general sales tax that taxes all goods at the same rate places a
higher tax burden on markets with more inelastic demands. Referring
again to the above example, if all goods are taxed at P1 P * , inelastic
goods pay (P1 P *) Q2 in taxes and suffer an excess burden of
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571
(P1 P *) (Q * Q2 ), whereas the burden on elastically demanded goods is (P1 P *) Q in taxes plus an excess burden of
1
2 ( P1 P *) ( Q * Q ). Comparing the two in an inequality, after dividing through by the common term (P1 P *), yields
1
Q2 + 1 2 (Q * Q2 ) > Q + 1 2 (Q * Q ).
(7)
The inequality in Equation (7) simplifies to Q2 > Q , which, by reference to Figure 1, is clearly true. All this says is that the tax paid plus the
excess burden is higher as a percentage of the total cost of the goods
for more inelastically demanded goods than for those with more elastic demands, giving inelastic demanders a bigger incentive to lobby
for tax rate reductions even when the tax rates are the same for all
goods. Intuition supports this because inelastic demanders pay more
of the tax, whereas elastic demanders avoid more of it by substituting
out of the taxed good.
Assume that excise tax rates are flexible to accommodate the
changes that would be necessary to maintain conformance with the
Ramsey rule. Next, assume that because of the informational problems discussed above, actual excise tax rates will be determined by the
strength of lobbying efforts of potential taxpayers rather than by actual demand elasticities. Then, assume that lobbying efforts are proportional to the potential cost that taxes will place on that group. It follows from Equation (7) that inelastically demanded goods will have a
lower tax rate than elastically demanded goods, rather than a higher
rate as the Ramsey rule would dictate. Following this logic, the creation of political institutions that would allow an omniscient and benevolent government to set taxes to conform to the Ramsey rule would
result in a tax structure with a greater excess burden than completely
uniform tax rates, once the assumption of omniscience is dropped and
interest group politics is incorporated into the political environment.
This conclusion is at odds with that of Becker (1983), Wittman
(1989), and Hettich and Winer (1988), who argue that interest group
politics in the political marketplace should result in an efficient allocation of resources. The conclusion is different because the assumptions
of the models are different. Both rely on the relative strength of opposing interest groups, but the biggest omission in this model compared
with the above-cited authors is that the expenditure side of the budget
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572
is left out. Interests lobby for lower taxes on themselves, but nobody in
this model is lobbying for more revenue. But real-world debates about
tax policy are this way too. Revenues are collected by the treasury, and
there is at best minimal connection between the revenues collected
and the expenditures they finance. Especially with smaller revenue
sources such as excise taxes, taxpayers view the taxes as a cost, but no
opposing interests in the political process view that revenue as their
gain.2 At the federal level, for example, total excise tax collections
comprise only 3.5% of total federal tax receipts, so interest groups that
desire higher expenditures are unlikely to lobby for increases in excise
taxes.
If the assumption that excise tax rates are designed by an omniscient and benevolent government is replaced by the assumption that
excise tax rates are a product of the political process, the flexible tax
structure that would be necessary to maintain a system of excise taxes
conforming to the Ramsey rule would result in a tax structure with a
greater excess burden than a sales tax with a uniform rate that raised
the same amount of revenue.3
The Ramsey rule says that under certain assumptions, the burden of
excise taxes is minimized when all goods are taxed in inverse proportion to their elasticities of demand. As with any deductive conclusion,
the Ramsey rule follows from certain assumptions. Setting excise
taxes according to the Ramsey rule will minimize the excess burden of
excise taxation if all goods are assumed to have perfectly elastic supply curves and if purchasers have separable preferences for all goods,
among other assumptions. There is no flaw in the logic of Ramseys
(1927) argument: Ramseys conclusions follow from his assumptions.
However, if the Ramsey rule is taken as a guide to public policy toward
excise taxes, then the preceding analysis claims that the models assumptions lead to a conclusion that is inappropriate as a guide to public policy.
All economic models, including the model that demonstrates the
Ramsey rule, make simplifying assumptionsand frequently, unreal-
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ture and applies to the Ramsey rule as well. The standard public finance literature treats taxes as a cost that government imposes on its
citizens. Buchanan advocated a fiscal exchange model of taxation, in
which taxes are viewed as the price paid for government goods and
services. Applying the fiscal exchange model to excise taxes, optimal
excise taxes would be designed to conform to the benefit principle of
taxation rather than the Ramsey rule. The benefit principle is applied
most straightforwardly with user charges, such as tolls for financing
roads. In this case, the toll acts just like a price, and there is no excess
burden because the price efficiently rations the use of the good.5 In deriving his rule to minimize the excess burden of excise taxes, Ramsey
(1927) assumed away this possibility of completely eliminating the
excess burden by analyzing the tax structure independently of expenditures. If user charges are not feasible, users could be taxed on their
use of a complementary good, such as applying an excise tax to motor
fuels to finance roads. Although not as directly as a price on road use,
the higher price of gasoline because of the tax would ration road use
someso in a manner similar to road pricing, it would lower the excess burden of taxation, again when taxes and expenditures are considered together.
Following this line of reasoning, excise taxes may be justified to
implement the benefit principle, and to the degree that they act like
prices on the goods they finance, they can reduce the excess burden of
taxes. The larger point, though, is that building on Buchanan (1976),
when both the revenue and expenditure sides of the budget are considered, the Ramsey rule is unlikely to minimize the excess burden of excise taxation, even when assuming an omniscient and benevolent government. Taxes designed to conform to the benefit principlerather
than the Ramsey rulecan completely eliminate the excess burden if
they can be designed to mimic market prices.
Even this conclusion needs to be tempered when the political environment is incorporated into the analysis. It is not always obvious who
benefits from particular expenditures, so even revenues from earmarked excise taxes are subject to appropriation through the political
process. For example, gasoline taxes, which largely are earmarked for
roads, have sometimes been diverted to finance mass transit expenditures or even bike paths under the justification that roadway users ben-
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To the degree that excise taxes are used as a tool of public finance,
they should be designed to conform with the benefit principle of taxation rather than the Ramsey rule, and they should be designed as a relatively permanent feature of a relatively inflexible fiscal constitution.
The Ramsey rule has been an unquestioned component of optimal tax
theory for three quarters of a century, but when it is analyzed within
the context of the actual political process within which taxes are designed rather than under the assumption that the tax structure is created by an omniscient and benevolent government, there is good reason to reconsider the Ramsey rule as a guide to optimal tax policy.
NOTES
1. Holcombe (1996) described the Ramsey rule in more detail. The rule can be modified to
take into account complications such as differences in supply elasticities and other factors, but
such complications are irrelevant to the points made in this article.
2. This would not be the case if the revenues were earmarked, but earmarking moves beyond
the bounds of the Ramsey rule, which simply looks at the collection of taxes independently of
where the revenue is spent.
3. The model presented here looks at the relative excise tax rates on two goods, but because
it does not incorporate the expenditure side, it does not determine an absolute level of taxes and
so does not determine an absolute level of excess burden.
4. This is not strictly true. McCloskey (1983) argued that models are employed as persuasive devices, and sometimes models are developed for purely aesthetic reasons. As Holcombe
(1989, 9) noted, quoting from an unknown source, Economists, like artists, are often in love
with their models.
5. This assumes that the road would be congested without the toll and that the toll rations the
use of the road. Without tolls, lack of congestion may signal excess capacity (the case is clearest
for roads with multiple lanes in each direction), in the sense that there is a marginal cost associated with building capacity, but the marginal user of the road places almost no value on its use.
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Randall G. Holcombe is the DeVoe Moore Professor of Economics at Florida State University, where he has taught since 1988. Prior to coming to Florida State, he was on the
faculty at Auburn University and Texas A&M University. His primary research interests
are in the areas of public finance and public choice. He is author of 10 books and more
than 100 articles. His most recent book is From Liberty to Democracy: The Transformation of American Government (2002).
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