PF06-Optimal Taxation - Chapter 16

Public Finance
- Optimal Taxation -
Sun Go
Chung-Ang University
Overview Commodity Equity Evasion Summary
Review
Efficiency of taxation
I Excess burden
I Indifference curve analysis
I Compensated demand curve analysis
I Discussion topics
I The theory of the second best
I Excess burden in general
I Housing service subsidy
I Income tax
I Differential taxation of inputs
Sun Go Optimal Taxation 2/80

Motivation
Positive questions
I Incidence: Who bears the burden?
I Excess burden: How much waste or inefficiency does tax
cause?
Normative questions
I Who should bear the burden?
I Is distribution of the burden fair? Equitable?
I How should the tax system be designed? To be as efficient as
possible?

Motivation
Trade off between progressivity vs. efficiency

I How should the tax system be designed to balance two goals?
Optimal taxation
I Optimal commodity taxation to maximize efficiency
I Optimal income taxation taking fairness into account
I Maximize tax revenue and minimize evasion

Overview
I Optimal commodity taxation

I Traditional equity criteria
I Optimal income taxation
I Other criteria for tax design
Textbook
I Ch. 16


Optimal commodity taxation

Optimal commodity taxation
Goal
I Raise revenue in the most efficient way
Settings
I Suppose X & Y are neither substitutes nor complements in a
competitive industry, and MC is constant
I Choose tX & ty to minimize Excess Burden
I Ad valorem tax rates on X and Y
I Subject to raising the required revenue

Neutral taxation
Neutral taxation is not necessarily efficient (nor optimal)

I Definition: Tax all goods at the same % rate (eg.
tX = ty = 10%
I This would keep all prices unchanged relative to one another
I Need to tax some goods more heavily than others

Neutral taxation
Why is neutral taxation inefficient?

I Taxing an inelastic good causes less EB per 1 won of revenue
raised
I Marginal EB
I The increase in EB by 1 unit increase in tax (1 one more tax
revenue)

Elastic demand

Inelastic demand

Note
If we virtually impose all the same tax rate on everything, including

leisure
I It will be exactly same as a lump sum tax
I But virtually impossible in the real world

Note
I Budget constraint: w (T − l) = Px X + PY Y where T is the

total time endowment
I Now tax X, Y, and l at the same ad valorem rate t (neutral
taxation)
I Then, the after tax budget constraint is
w T̄ = (1 + t)PX X + (1 + t)PY Y + (1 + t)wl
1
I That is, 1+t w T̄ = PX X + PY Y + wl
1
I This is equivalent to the lump sum tax of 1+t w T̄
I No distortion in the relative price system
I But taxing leisure is virtually impossible

Inverse elasticity rule
tX ηYC
I Optimal tX & tY satisfy tY = ηXC
I ηXC = compensated elasticity of demand for X

Again, tX ηXC = tY ηYC

I tX : % change in PX
%∆DXC
I ηXC = %∆P
I Thus, tX ηXC = %∆DXC
I This means that “the percentage change in the quantity of X
demanded must equal the percentage change in the quantity
of Y demanded.”
more responsive goods, we have to set the tax smaller,

bcs can change the great quantity demand and thus increase tax burden
to minimize excess burden, we have to set smaller tax or lower tax
if the good is inelastic product, we can set the tax rate to be larger
to equalize the demand of the goods.

Proof
Y
I EBX = 12 ηX PX XtX2 and EBY = 12 ηY PY XtY2
I We assume that X and Y are uncorrelated
I EB = EBX + EBY = 21 ηX PX XtX2 + 12 ηY PY XtY2
I Suppose the required tax revenue is R, then, the budget

constraint is
I PX XtX + PY YtY = R

Proof (cont.)
I Our problem is to choose tX & tY to minimize EB subject to
the budget constraint
ny Y
I L = 12 ηX PX XtX2 + 12 ηX PY XtY2 − λ(PX XtX + PY YtY − R)
I The first order conditions are

∂L
I
∂tX = ηX PX XtX − λPX X = 0, ηX tX = λ
∂L
I
∂tY = ηY PY YtY − λPY Y = 0, ηY tY = λ
I Therefore, tX ηX = tY ηY

Ramsey rule
I To raise a fixed amount of revenue, we minimize excess burden

by imposing taxes such that the consumption of each good
decreases by the same percentage
I ∆X = ∆Y
X Y

Ramsey rule
Lower tax rate for the relatively elastic goods, (Diamond)

Higher tax rate for the relatively inelastic goods (Food)

Corlett-Hague Rule
In case of two commodities
I Efficient taxation requires taxing commodity complementary to
leisure at a relatively high rate
I High taxes on complements to leisure provide an indirect way
to “get at” leisure
Remind our example on the “theory of the second best”

I We have a tax on labor income (income tax)
I Income tax is a subsidy on leisure, creating excess burden
I To reduce EB, we should
I Tax complements to leisure more: movies, mobile games,
vacation housing
I Tax substitutes less: textbooks, pens, paper, rush hour
commute


Optimal income taxation

Optimal income tax problem
To maximize social welfare while taking account that agents will be

maximizing
Seek to balance equity and efficiency concerns

I Equity: government value redistribution (from rich to poor)
I Efficiency: redistribution is costly in terms of efficiency loss
due to disincentives of taxes (taking from rich) and transfers
(giving to poor)
I Depends on how much you care about these two parts

Motivation
How do we make the tax system both efficient and fair?

I Edgeworth’s model
I Stern’s optimal income tax model
I Gruber and Saez’s simulation
I Mirless’s model
I Mankiew, Weinzierl, and Yagan (2009)

Traditional equity criteria

Traditional equity criteria
I Benefits-received principle
I Minimization of administration and compliance costs
I Horizontal equity
I Vertical equity

Benefits-received principle
I Those who benefit from government expenditures should pay

the associated taxes
I Examples: bridge tolls, gasoline tax for roads

Minimization of administration and compliance costs
I Government: administration cost

I Taxpayers: compliance cost

Horizontal equity
I Those having the same ability to pay (as measured, say, by

income) should pay the same tax
I If IA = IB , then we must hold TA = TB

Vertical equity
I Those having greater abilities to pay should pay

“appropriately” higher taxes
I If IA > IB , then we must hold TA > TB

Examples
Example 1
A B C D
Income 100 200 100 200
Tax 50 30 50 30
Example 2
A B C D
Income 100 200 100 200
Tax 50 70 30 90


Edgeworth’s model

Edgeworth’s model
Setting
I Two people with income Y1 & Y2
I Choose taxes T1 (for person 1) & T2 (for person 2)
I To maximize Utilitarian social welfare
I W = U(Y1 − T1 ) + U(Y2 − T2 ) = U(N1 ) + U(N2 )
I W: social welfare
I N: net income
I Assume same utility function for both
I Subject to T1 + T2 = R̄

Edgeworth’s model
I Then, T2 = R̄ − T1
I The problem becomes to choose T1
I To maximize W = U(Y1 − T1 ) + U(Y2 − R̄ + T1 )
F.O.C.
I dW dU
= − dN + dU
=0
dT1 1 dN2
dU dU
I Therefore, dN1 = dN2

Edgeworth’s model
Assumptions
I Same utility functions
I Y1 & Y2 are fixed: No disincentive to make work less
I Justice of maximizing U1 + U2

Edgeworth’s model
Example
I Y1 = 23 million won
I Y2 = 17 million won
I R̄ = T1 + T2 = 10 million won
I Then, net available income = Y1 + Y2 − R̄= 30 million won
between the two
dU dU
I When U are the same, dN 1
= dN 2
leads to N1 = N2 = 15
million won
I Therefore, T1 = 8 million won and T2 = 2 million won
I A radically progressive tax structure
I MTR on high income individuals are 100%

Edgeworth’s model

Edgeworth’s model
Normative Premises
I It’s a valid index of social welfare to add utility functions
I There’s no ethical imperative to leave someone with some of
their earning
A key problem
I Assume utility depends only on income, not on leisure
I = Taxes cause no disincentives


Stern’s model

Stern’s optimal income tax model
I Now assume consumers maximize U(income, leisure)

I Choose a “flat tax” (constant MTR)
I T = −α + t × income : linear income tax schedule
I Note: this is a progressive tax (ATR increases as T ↑)
I When income is smaller than a threshold level, an individual
receives subsidy rather than paying tax


Two problems
Individual problem
I Choose L
I To Max U(C,L)
I Subject to C = (1 − t)w (H̄ − L) + α
Government problem
I Choose α and t
I To Max social welfare
W = F (U(C1 , L1 ), U(C2 , L2 ), . . . , U(Cn , Ln ))
I Utilitarian: W = Σi U(Ci , Li )
I Subject to raising required revenue R̄ = Σi (tw (H̄ − Li ) − α)

Depending on α and t, people’s choice of L will vary

I Trade off: higher α and t
I More progressive taxation (more redistribution from the rich to
the poor)
I But greater work disincentives (due to the higher marginal tax
rate)

Simulation result
Stern’s assumptions
I A small positive elasticity of labor supply = 0.1
I The elasticity of substitution between Leisure and Y is 0.6
I Required revenue is 20% of the income
Simulation result
I t = 19%
I This is much lower than the top marginal tax rate in the real
world


Gruber and Saez (2002)

Gruber and Saez
The elasticity of taxable income with respect to taxation

I Using a panel of tax returns, estimated the overall elasticity of
taxable income is about 0.4
I Small income effects of tax changes on reported income
I Mostly driven by high incomers
I Elasticity 0.57 if incomes >=100,000 per year
I Elasticity 0.33 or lower if income less than 100,000 per year

Gruber and Saez

Simulation
I Assume four income tax brackets
I Optimal tax: Lower MTR in the high income tax bracket
I This still can be progressive because ATR increases as T ↑
Example: with redistributive tastes (social weights are decreasing

with income)
I T = −α + t × income and α = $11,000
I Result
I t = 68% if $0<= income < 10,000
I t = 66% if $10,000<= income < 50,000
I t = 56% if $50,000<= income < 100,000
I t = 49% if $100,000<= income
I

Gruber and Saez

Intuition
I Lower MTR for the high income people
I Increase of total income and tax revenue
I Lower inequality by using extra tax revenue (subsidy or social
transfer for the low income class)
I Total social welfare increases
Note: this is highly progressive
Income Subsidy or Tax Net Income ATR

0 11000 11000
10000 4400 14400 -0.44
50000 -17000 33000 0.34
100000 -38000 62000 0.38

Optimal taxation
In the linear income tax schedule, optimal α and t will be higher if

(taxes are higher and there is more redistribution to the poor)
I Elasticity of labor supply is lower (thus, less EB is caused by
income tax)
I Social concerns about inequality is greater
I The amount of inequality that exists in the society is greater


Mirless (1971)

Mirrlees model
Mirrlees (REStud, 1971)

I First mathematically rigorous treatment of optimal income tax
problem with incentive effects
I Central paper in the economics of taxation

Mirrlees model: Setup
Individual
I All individuals have the same utility u(c,l) with c after tax
income and l labor supply
I This puts aside possibility of differences in preferences
I People differ according to their skills or wage rates w
I Exogenous distribution (and density) of wage rates: F(w) and
f(w) (sum to one)
I Individual with skill w supplying l earns wl
I Everyone works (= Intensive margin only; no extensive margin)
I Tax is based on earnings, so after-tax income c = wl - T(wl)
I Individual choose l so as to maximize u(wl - T(wl, l)
I FOC: w (1 − T 0 (wl))uc + ul = 0
I e.g., MRS = after-tax wage

Mirrlees model: Setup
Government
I Social welfare function G(.): increasing and concave
I Concavity means that social welfare of increasing utility is
decreasing in u redistribution or fairness
I Marginal increase for rich < marginal increase for poor
I = Taste for redistribution
I G(u)=u corresponds to utilitarian case
Government program is to maximize social welfare subject to

budget constraint and individual optimization
R
I W = G (u(c, l))f (w )dw
I subject to
R
I T (wl)f (w )dw ≥ E (multiplier ρ )
I w (1 − T 0 (wl))uc + ul = 0

Mirless’s model
what is the true ability of each individual?

Summary they might now the revenue but the ability not
I Income is observable, but ability is not
I When income tax is progressive, high-ability individuals may
decrease work effort
I A game of imperfect information between taxpayers and the
social planner
I Incentivizing individuals to voluntarily reveal their ability
I Example: A lower MTR in the high income bracket

Mirless’s model
Numerical illustration
I A lump-sum transfer + income tax
I Subject to raising 10% of national income as tax
I And maximizing social welfare
I The tax rate structure affects the individual incentive to work
I Individuals maximize utility, which is a Cobb-Douglas function
of consumption and labor.
I Assuming a lognormal skill distribution with a standard
deviation of 0.39

Utilitarian case
Maximize the unweighted sum of individual utility

z = income, x = consumption
we see MTR is decreased as income increase (min. work disincentive)

while ATR is increasing. meaning the tax is progressive

Some equity considerations
Maximize social welfare, with preference for equality

z = income, x = consumption
in korea, the higher income MTR

is increasing


Mankiw, Weinzierl, and Yagan (2009)

Findings from the literature

I The optimal marginal tax rate is between 48 and 50% in the
linear income tax schedule
I Considerably less than 100% suggested by Edgeworth’s model
I “Even quite modest incentive effects appear to have important
implications for optimal marginal tax rates”
I The optimal lump-sum grant to low ability workers is just over
60% of the average income per worker

Eight lessons from the literature

I Optimal taxation in the cost-benefit framework
I Optimal marginal tax rate schedules depend on the distribution
of ability
I The optimal marginal tax schedule could decline at high
incomes
I From simulations
I A flat tax, with a universal lump-sum transfer, could be close
to optimal
I The optimal extent of redistribution rises with wage inequality
I Information asymmetry
I Taxes should depend on personal characteristics as well as
income

Eight lessons from the literature (cont.)

I Do not distort the allocation of factor inputs and individuals’
consumption choices
I Only final goods ought to be taxed, and typically they ought
to be taxed uniformly
I Dynamic models
I Capital income ought to be untaxed, at least in expectation
I In stochastic dynamic economies, optimal tax policy requires
increased sophistication

the research is still continued……

Other concerns and tax evasion

Tax compliance cost
Reducing tax compliance cost

I Offering incentives
I Easy tax filing
I Easy tax code
cost burdened by the tax payer to fulfill tax

Evasion vs. avoidance
I Tax avoidance: Altering behavior in such a way as to reduce

one’s legal tax liability
I Tax evasion: not paying taxes legally due

Tax avoidance

Tax avoidance

Tax avoidance

Tax evasion theory
I Suppose R is the amount of underreporting

I MB of tax evasion = t
I For every underreported won, the benefit would be t
I MC of tax evasion = ρ× Marginal penalty
I ρ is the probability of being audited
I Marginal penalty is greater as R increases

Choice of tax evasion

Zero tax evasion
Raise ρ or marginal penalty
decrease compliance cost and increase incentive.

because hiring tax auditor is expensive.

Summary

Summary
Re-cap: Optimal taxation

I Optimal commodity taxation
I Optimal income taxation
I Other criteria for tax design
Next class
I Income tax (Ch. 17)

PF06-Optimal Taxation - Chapter 16

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Public Finance

Sun Go Optimal Taxation 2/80

Sun Go Optimal Taxation 3/80

Trade off between progressivity vs. efficiency

Sun Go Optimal Taxation 4/80

I Optimal commodity taxation

Sun Go Optimal Taxation 5/80

Sun Go Optimal Taxation 6/80

Optimal commodity taxation

Sun Go Optimal Taxation 7/80

Optimal commodity taxation

Sun Go Optimal Taxation 8/80

Neutral taxation is not necessarily efficient (nor optimal)

Sun Go Optimal Taxation 9/80

Why is neutral taxation inefficient?

Sun Go Optimal Taxation 10/80

Sun Go Optimal Taxation 11/80

Sun Go Optimal Taxation 12/80

If we virtually impose all the same tax rate on everything, including

Sun Go Optimal Taxation 13/80

I Budget constraint: w (T − l) = Px X + PY Y where T is the

Sun Go Optimal Taxation 14/80

Inverse elasticity rule

I ηXC = compensated elasticity of demand for X

Sun Go Optimal Taxation 15/80

Inverse elasticity rule

Again, tX ηXC = tY ηYC

more responsive goods, we have to set the tax smaller,

Sun Go Optimal Taxation 16/80

Inverse elasticity rule

I We assume that X and Y are uncorrelated

I EB = EBX + EBY = 21 ηX PX XtX2 + 12 ηY PY XtY2

I Suppose the required tax revenue is R, then, the budget

Sun Go Optimal Taxation 17/80

Inverse elasticity rule

I The first order conditions are

Sun Go Optimal Taxation 18/80

I To raise a fixed amount of revenue, we minimize excess burden

Sun Go Optimal Taxation 19/80

Lower tax rate for the relatively elastic goods, (Diamond)

Sun Go Optimal Taxation 20/80

Remind our example on the “theory of the second best”

Sun Go Optimal Taxation 21/80

Sun Go Optimal Taxation 22/80

Optimal income taxation

Sun Go Optimal Taxation 23/80

Optimal income tax problem

To maximize social welfare while taking account that agents will be

Seek to balance equity and efficiency concerns

Sun Go Optimal Taxation 24/80

How do we make the tax system both efficient and fair?

Sun Go Optimal Taxation 25/80

Traditional equity criteria

Sun Go Optimal Taxation 26/80

Traditional equity criteria

Sun Go Optimal Taxation 27/80

I Those who benefit from government expenditures should pay

Sun Go Optimal Taxation 28/80

Minimization of administration and compliance costs

I Government: administration cost

Sun Go Optimal Taxation 29/80

I Those having the same ability to pay (as measured, say, by