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Lecture 6

Microeconomic Interventions:
Economic Policy Analysis
Dragana Radicic
Redistributive policies and optimal taxation
• Redistributive policies
• Government action aimed at obtaining a certain distribution of
income (or wealth) considered to be optimal, i.e. at modifying the
distribution produced by the operation of the market.
• A special case arises when the government selects its criteria
for allocating the tax burden, on which the final distribution of
income and wealth depends.
• An optimal tax maximises social welfare in terms of both
equity and efficiency.
Theories of justice and the principles of
• The fundamental principles of equity are horizontal equity and vertical equity.
• Horizontal equity requires that individuals in the same position in all
relevant aspects are treated equally.
• Vertical equity requires that individuals in different positions are treated
• The productivity principle = everyone has an inviolable natural right to the
product of his labour and capital.
• Any acceptable redistribution policy would be that of voluntary transfers (e.g.
• A more moderate version
• Government should ensure equal opportunity.
The redistribution principle
• The redistribution principle = differences in ability do not justify distributive
inequalities, and redistribution policies should be used to adjust incomes to meet
the needs of individuals or to allow all persons to achieve some basic
• Accepting a simple utilitarian SWF has egalitarian implications:
• Social welfare is maximised when individuals have equal utility.
• Equal utility can be achieved only with equal incomes.
• Thus equal distribution of income maximises social welfare.
• The same result of equal income distribution can be derived from Rawls’ theory
of justice if identical utility functions for the various individuals are assumed.
• According to Sen, we should ensure that individuals have equal capacity to
carry out their functionings.
• If individuals are in the same situation, they should be treated in the same
Redistribution policies
• Budget policy is the primary tool for achieving equity goals.
• Taxes
• Cash transfers
• In-kind transfers
• The effects of budget measures do not primarily depend on the total
volume of expenditures and revenues but rather on their composition
and structure.
• Composition = direct and indirect taxes
• Structure of taxes = proportional, progressive or regressive
• The average tax rate is the ratio between the total amount of taxes paid
and the tax base.
• The marginal tax rate is the ratio between the increase in the value of
taxes and the increase in the value of the tax base.
• Proportional taxation: average tax rate = marginal tax rate
• Progressive taxation: marginal tax rate > average tax rate
• Regressive taxation: marginal tax rate > average tax rate
• An income tax can be made progressive in several ways:
• By tax deductions (credits)
• By continuous progressivity
• By tax brackets
Utilitarianism, ability to pay and optimal taxation

• We need a practical criterion that incorporates the principles of

horizontal and vertical equity.
• E.g. ability to pay
• Two (unrealistic) assumptions
• Utility depends on income alone (what about working time?)
• Income is independent from the tax system
• If they hold, then the optimal taxation of two individuals with different
pre-tax incomes would result in the equal distribution of net incomes
(thus progressive taxation) and the principle of tax equity used is that
of equal marginal sacrifice.
Utilitarianism, ability to pay and optimal
• How to avoid issues arising from unrealistic assumptions?
• Taxes should not be levied in relation to an indicator of
ability to pay (e.g. income), that not only depends on the
choice of leisure time but also influences this choice through
substitution effect.
• Taxes should instead be based on indicators of ability to pay,
such as skill or talent.
• Problems with the above proposition
• Asymmetric information = government cannot fully observe
person's skill and talent
Characteristics of optimal tax
• In the presence of an incentive constraint, a marginal tax rate above
100 percent will never be optimal.
• The marginal tax rate will be lower the larger is the fraction of the
population earning the income level that pays that marginal tax rate.
• The marginal tax rate on the highest-ability individual should be zero.
• The marginal tax rate is lower the higher is productivity of the group
of people involved.
• The marginal tax rate is lower the higher is the elasticity of the labour
Optimal commodity taxation
• Indirect taxes on consumption or sales
• Excise taxes
• Sales taxes (either full-value taxes or value-added taxes)
• Ramsey rule: if lump-sum taxes cannot be levied, an optimal
commodity tax system can be devised.
• Goods whose demand is more inelastic should be taxed more.
• In reality, higher taxes would be set on luxury goods and
lower rates would hit essential goods.
Optimal commodity taxation
• The use of indirect taxation for redistributive purposes has a
number of drawbacks:
• The administrative complexity of managing the system of multiple
tax rates
• Setting lower tax rates on certain goods normally benefits not only
the consumers of those goods but also their producers.
• Distortionary effects of taxing goods
Alternative redistribution and income
maintenance schemes
• Welfare schemes:
• Basic income schemes
• Schemes providing for positive income taxes on incomes above a given level and
negative income taxes for those below that level
• Wage subsidy schemes
• Workfare schemes: require welfare recipients to work in government-
provided jobs.
• If income-generating abilities were observable, then welfare schemes are
preferable, in particular a wage subsidy scheme.
• If income-generating abilities were not observable, then workfare schemes
provide an optimal solution.
• Because of high administrative costs, the government may resort to equal
transfers for all, which does not reduce inequality, but can prevent poverty.
The welfare state
• The welfare state = government activities comprising cash transfers,
health, education, food provision, housing and other essential services.
• Four models of welfare state:
• The conservative-corporatist model
• The liberal model
• The pure liberal model
• The reform liberal model
• The social democratic model
• The catholic model
The welfare state
• The conservative-corporatist model
• Austria, Germany and Italy until the second world war
• Redistribution through family and the private sector (e.g. charity)
• The liberal model
• United States, Canada and Australia
• Government intervention at the margin
• The social democratic model
• Scandinavian countries
• Seeks to promote equality not only between workers but between all citizens.
• The catholic model
• Government intervenes only when the individual, the family and the local
community fail to provide support.
Criticism of redistribution policies, flat-rate
taxation and the basic income
• “Redistributive pessimism” is largely unfounded because:
• Empirical studies should include not only the number of hours worked, but
also the labour force participation rate.
• There is no reason to focus only on labour supply, which is an indicator of
allocative (static) efficiency. Dynamic efficiency might be even more
• Alternative suggestions:
• The basic income (or citizen’s income)
• Means guaranteeing a basic income to every citizen, irrespective of other sources of
• Flat-rate income tax
• Would replace the current income tax and social security contributions with a single
marginal tax rate on all income above some threshold.