Tax Inefficiencies and Their Implications For Optimal Taxation

Tax Inefficiencies and Their
Implications for Optimal Taxation 20

20.1 Taxation and Economic Efficiency
20.2 Optimal Commodity Taxation
20.3 Optimal Income Taxes
20.4 Tax-Benefit Linkages and the Financing of Social
Insurance Programs
20.5 Conclusion
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 1 of 40
Definition
• Incidence: effect of policies on distribution of economic pie

• Efficiency or deadweight cost: effect of policies on size of the
pie
• Focus in efficiency analysis is on quantities, not prices
• In this chapter, we will learn how attempts to minimize tax

burden have efficiency costs for society.
Efficiency Cost: Introduction
• Government raises taxes for one of two reasons:

– To raise revenue to finance public goods
– To redistribute income
• But to generate $1 of revenue, welfare of those taxed
falls by more than $1 because the tax distorts behavior
• How to implement policies that minimize these efficiency
costs?
– Start with positive analysis of how to measure
efficiency cost of a given tax system
C HAPT E R 2 0 ■ TAX I N E F F I C I E N C I E S AN D T H E I R I M P LI CAT I O N S F O R O PT I MAL TAXAT I O N
20
Tax Inefficiencies and Their Implications for Optimal
Taxation
• Usually, the market produces efficient outcomes.

• In the absence of market failures, social efficiency is
maximized at the competitive equilibrium without government
intervention.
• Taxes interfere in the market and reduce efficiency.
• If there is some action that market participants can undertake
to minimize the burden of taxation, they will do so.
• People substitute away from the taxed product, using less-
efficient alternatives.
o Example: Eight-person motorcycles Rikshaws
• Some taxes have much larger efficiency costs than others.
20.1
Taxation and Economic Efficiency: Graphical
Approach
Price per S2
gallon (P)
S1
Tax =
$0.50
B
P2 = $1.80
E Deadweight loss, DWL
P1 = $1.50 A
F D
P3 = $1.30 C
G
D1
0 Q2 = 90 Q1 = 100 Quantity in
billions of
gallons (Q)
20.1
Taxation and Economic Efficiency
• The social efficiency effects of taxation are the effects of

taxation on quantities.
• In the absence of taxes: Price = SMB = SMC
• The tax drives a wedge between SMB and SMC, preventing
mutually beneficial trades from occurring.
• At market equilibrium, the sum of consumer surplus and
producer surplus is at its maximum.
• The foregone surplus from taxation is called the deadweight
loss (DWL).
20.1
Elasticities Determine Tax Inefficiency
(a) Inelastic demand (b) Elastic demand

Price per S2 Price per
S2
gallon (P) gallon (P)
S1 S1
Tax Tax
B
P2 B
DWL P2
A
P1
P1
C A
C D1
DWL
D1
0 Q2 Q1 Quantity in 0 Q2 Q1 Quantity in
billions of billions of
gallons (Q) gallons (Q)
20.1
Elasticities Determine Tax Inefficiency
• Deadweight loss is determined by changes in quantities when a

tax is imposed.
• Deadweight loss is caused by individuals and firms making
inefficient consumption and production choices in order to
avoid taxation.
• The inefficiency of any tax is determined by the extent to which
consumers and producers change their behavior to avoid the
tax.
• Deadweight loss is determined by the reduction in socially
efficient trades
20.1
• Equilibrium quantity maximizes social surplus. Any change in

quantity from the equilibrium point leads to inefficiency.
• Inefficiency is proportional to the change in quantity induced
by the tax.
• The more elastic is demand or supply, the larger the DWL.
Efficiency Cost: Qualitative Properties
• Excess burden increases with square of tax rate
• Excess burden increases with elasticities
20.1
Determinants of Deadweight Loss
• The formula for DWL is
o and are the elasticity of supply and demand is the

tax rate, Q and P are the quantity and price.
• DWL rises with the square of the tax, so marginal DWL
rises with the tax rate.
o Marginal deadweight loss: The increase in
deadweight loss per unit increase in the tax.
Deadweight Loss
• Deadweight loss rises with the elasticities of demand and
supply;
• The more opportunities market participants have to consume
or produce substitutes the greater the inefficiency they will
create by substituting.
• The distortion from any given amount of tax is greater as the
existing tax rate increases.
20.1
Marginal DWL Rises with Tax Rate
S3
Price Tax =
of gas $0.10 S2
D S1
P3
B
P2 Tax =
$0.10
P1 A
DWL
C
E
D1
0 Q3 Q2 Q1 Quantity of gas
Deadweight Loss and the Design of Efficient Tax

Systems
• Deadweight Loss and the Design of Efficient Tax Systems

• Progressive Tax Systems can be less Efficient
• Implication: Government should smooth tax rates over time
Tax Policy Implications
• With many goods, the most efficient way to raise tax

revenue is:
• Tax inelastic goods more (e.g. medical drugs, food)
• Spread taxes across all goods to keep tax rates

relatively low on all goods (broad tax base)
• These are two countervailing forces; balancing them
requires quantitative measurement of excess burden
20.1
A Tax System’s Efficiency Is Affected by a Market’s
Preexisting Distortions
• Since marginal DWL rises with the tax rate, pre-existing

distortions affect the efficiency of a new tax.
o Pre-existing distortions: Market failures, such as
externalities or imperfect competition, that are in place
before any government intervention.
o Externalities Imperfect competition, existing taxes.
20.1
A Tax System’s Efficiency Is Affected by a Market’s
Preexisting Distortions
20.1
Progressive Tax Systems Can Be Less Efficient
There can be large efficiency costs to moving from a
proportional to a progressive tax system
• Because the DWL rises with , progressive tax systems
can be less efficient than proportional ones.
• Example:
• Suppose there are two people, one with a wage of
$10/hour and one with a wage of $20/hour.
• For both, a 10% rise in wages leads them to supply
10% more labor (elasticity of labor supply = 1).
• Elasticity of labor demand is also one.
20.1
No Tax Proportional Progressive

Tax Tax
Tax rate below $10,000 0 20% 0%

Tax rate above $10,000 0 20% 60%
Low wage hours 1,000 864 1,000
Low wage DWL 0 $115.7 0
High wage hours 1,000 864 837
High wage DWL 0 $231.4 $566.8
Total DWL 0 $347.1 $566.8
20.1
Why is the deadweight loss larger for the higher-wage

worker despite the same reduction in hours worked?
• In a competitive labor market, wage equals the
marginal product of labor, so the high-wage worker has
a higher marginal product of labor.
• Society loses twice as much when the high-wage
workers reduce their hours than when the low-wage
workers reduce their hours.
• The proportional tax is levied on a total of $30,000 of earnings.

• The progressive tax is levied on a total of only $10,000 of
earnings (the second $10,000 of earnings of the high-wage
worker).
• To raise the same amount of revenues on this smaller tax base,
the progressive tax must impose a higher tax rate, and a higher
tax rate means a higher marginal deadweight loss.
• The more you load taxes on one source, the faster deadweight
loss rises. the most efficient tax systems are those that spread
the burden of taxation the most broadly, so that the tax rate,
the driver of deadweight loss, can be minimized
20.1
Governments Should “Smooth” Tax Rates Over Time
• Government efficiency in taxation over time is maximized by tax

smoothing, by having a relatively constant tax rate over time
rather than high taxes in some periods and low taxes in others.
• The marginal deadweight loss rises with the tax rate implies
that governments should not raise and lower taxes as they need
money but should instead set a long-run tax rate that will meet
their budget needs.
• High-then-low tax rates produce a larger DWL then steady
medium tax rates.
Optimal Commodity Taxation: Introduction
• Combine lessons on incidence and efficiency costs to analyze

optimal design of commodity taxes
• What is the best way to design taxes given equity and

efficiency concerns?
Overview of Optimal Taxation
• From an efficiency perspective, would finance government

purely through lump-sum taxation
• With redistributional concerns, would ideally levy individual-
specific lump sum taxes
o Tax higher-ability individuals a larger lump sum
• Problem: cannot observe individuals’ types

o Therefore must tax economic outcomes such as income
or consumption, which leads to distortions
Optimal Commodity Taxation
• We move from Positive question of how to measure

deadweight loss
to the normative question of,
how the existence of DWL should be taken into account in
the design of the tax system
• How can we raise a given amount of revenue with the least
amount of distortion?
• The normative question is addressed with reference to two
types of taxes.
1. Commodity taxation,
2. Taxation of income
• James Mirrlees (1971) launched the second wave of optimal tax

models by suggesting a way to formalize the planner’s problem.
• Individuals differ in their innate ability to earn income.
• The planner can observe income.
• If the planner taxes income in an attempt to tax those of high
ability, individuals will be discouraged from exerting as much
effort to earn that income.
• By recognizing unobserved heterogeneity, diminishing marginal
utility of consumption, and incentive effects, the Mirrlees
approach formalizes the classic tradeoff between equality and
efficiency that real governments face, and it has become the
dominant approach for tax theorists.
Conti-
• In the Mirrlees framework, the optimal tax problem

becomes a game of imperfect information between
taxpayers and the social planner.
• The planner would like to tax those of high ability and
give transfers to those of low ability
• Mirrleesian analysis often relies on the “revelation
principle.”
20.2
Ramsey Taxation: The Theory of Optimal
Commodity Taxation
• Optimal commodity taxation: Choosing the tax rates

across goods to minimize deadweight loss for a given
government revenue requirement.
• 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, that is, .
• Value of additional government revenues: is the value
of having another dollar in the government’s hands
relative to its next best use in the private sector.
Ramsey Rule
• MDWL is a positive function of the tax rate; higher taxes lead to

a higher marginal deadweight loss because they move the
market farther from the competitive equilibrium.
• Policy analysts typically do not have a measured value for λ. The
Rule is used for tax reform and the costs and benefits of shifting
from an existing pattern of commodity taxes to another pattern
that raises the same amount of revenue.
• If λ is large, it implies that additional government revenues are
quite valuable relative to keeping the money in private hands.
• If λ is small, the additional government revenues have little value
relative to the value private individuals place on having that
money.
Inverse Elasticity Rule
Ramsey Formula: Limitations
• Ramsey solution: tax inelastic goods to minimize

efficiency costs
• But does not take into account redistributive motives
• Necessities likely to be less elastic than luxuries
• Therefore, optimal Ramsey tax system is likely
regressive
• Diamond (1975) extends Ramsey model to take
redistributive motives into account
• Basic intuition: replace multiplier l with average
marginal utility for consumers of that good
20.2
Equity Implications of the Ramsey Model
Imagine that the government had only two goods it could tax, cereal
and luxury cars.
• Elasticity of demand for luxury cars is much higher than that for
cereal.
• The inverse elasticity rule would suggest that the government tax
cereal much more highly than luxury cars.
• This means taxing the good consumed by poor people more
heavily.
• This outcome, while efficient, might violate a government’s sense
of tax fairness across income groups (vertical equity).
• An optimal commodity tax framework can address equity
concerns by taking into account not only the elasticity of each
commodity but also the income distribution of its consumers.
20.2
APPLICATION: Price Reform in Pakistan
• Commodities are taxed or subsidized throughout the developing
world.
• Any government intervention that moves consumption away
from its optimal level is inefficient
• Deaton (1997) studied the demand for subsidized goods in
Pakistan, looking at their elasticity, and the income of people
who consume it.
Good Subsidy Elasticity Consumed by?
Wheat 40% −0.64 Poor
Rice 40% −2.08 All
Oil/Fat −5% −2.33 Poor
20.2
APPLICATION: Efficiency Consequences of Taxes
and Subsidies in Pakistan: Wheat (Inelastic Demand)
20.2
APPLICATION: Efficiency Consequences of
Subsidies in Pakistan: Rice (Elastic Demand)
20.2
APPLICATION: Efficiency Consequences of Taxation
in Pakistan: Oils and Fats (Elastic Demand)
Tax Reforms
• The rather abstract notions of optimal commodity taxation

can find very useful application in practice.
• Armed with these concepts and the tools of empirical
analysis, economists can provide important advice to policy
makers on appropriate reforms to commodity tax and
subsidy systems
20.3
Optimal Income Taxes
• Most tax revenue in the developed countries is from income

taxes.
• Optimal income taxation: Choosing the tax rates across
income groups to maximize social welfare subject to a
government revenue requirement.
• Social welfare function guides the trade-off between
progressivity and efficiency.
20.3
A Simple Example: Assumptions
1. Everyone in society has the same utility functions:

.
2. Diminishing MU of income.
3. Total income in society is fixed, not determined by
individual choices that might respond to tax rates.
4. Society has an equally-weighted utilitarian social
welfare function:
20.3
A Simple Example
Under these assumptions:
• The optimal income tax system is one that leaves everyone with
the same level of post-tax income.
• People with income below average would receive a transfer to
increase their incomes to average.
• The marginal tax rate under this system is 100%.
• If income responds to taxes, the optimal marginal tax rate is
lower.
20.3
General Model with Behavioral Effects
• With behavioral effects, taxes reduces hours worked.

o At high tax rates, tax revenue falls with the tax
rate; no one works under a 100% tax rate.
• The optimal tax system trades off the efficiency cost of
taxation against the benefits of redistribution.
• The rule is to set the income for group such that
• is MU for group , the marginal revenue, and is the

value of government revenue.
20.3
The Laffer Curve
20.3
General Model with Behavioral Effects
Optimal income taxation balances:

• Vertical equity: Social welfare is maximized when
those who have a high level of consumption, and thus
a low marginal utility, are taxed more heavily, and
those who have a low level of consumption, and thus
a high marginal utility, are taxed less heavily.
• Behavioral responses: As taxes rise on any one group,
individuals in that group may respond by earning less
income.
20.3
An Example: Optimal Income Taxes with Two Types
20.4
Tax-Benefit Linkages and the Financing of Social
Insurance Programs
• So far we have ignored tax-benefit linkages.

• Tax-benefit linkages: Direct ties between taxes paid
and benefits received.
• Introducing these linkages enriches changes the story,
since many payroll taxes are directly linked to benefits.
20.4
Tax-Benefit Linkages: Graphical Representation
Wage
S1 =
Taxes C SMC
G
S2
A
W1 Benefits
F
W2 B
D
E
D1 =
D2
SMB
0 L2 L3 L1 Quantity of labor (L)
20.4
Tax-Benefit Linkages: Graphical Representation
20.4
Perfect Linkage Eliminates the DWL
20.4
Issues Raised by Tax-Benefit Linkage Analysis
• Why doesn’t the private sector provide these

benefits?
o Market failures may plague the market.
• When are there tax-benefit linkages?
o The tax-benefit linkage is strongest when taxes
paid are linked directly to a benefit for workers.
• What Is the evidence on tax-benefit linkages?
o Financing is borne by workers in the form of lower
wages and not lower employment.
20.4
EVIDENCE: A Group-Specific Employer Mandate
• In the mid-1970s, states began to mandate insurance

benefits for pregnant women.
• These laws raise the cost of insuring, and hence
employing, certain groups.
• Compared to other groups in the same states, or the
same groups in states without mandated benefits:
o Wages fell.
o Labor supply did not.
• Suggests that benefit linkage is near complete.
20.5
Conclusion
• The fundamental issue in designing tax policy is the

equity-efficiency trade-off.
• Tax efficiency comes down to two key principles:
o The more elastically supplied or demanded the
good, the larger the deadweight loss from the tax.
o The higher the tax rate, the larger the incremental
deadweight loss of taxation.

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Tax Inefficiencies and Their

Implications for Optimal Taxation 20

• Incidence: effect of policies on distribution of economic pie

• In this chapter, we will learn how attempts to minimize tax

• Government raises taxes for one of two reasons:

• Usually, the market produces efficient outcomes.

• The social efficiency effects of taxation are the effects of

(a) Inelastic demand (b) Elastic demand

• Deadweight loss is determined by changes in quantities when a

• Equilibrium quantity maximizes social surplus. Any change in

Efficiency Cost: Qualitative Properties

• Excess burden increases with square of tax rate

• Excess burden increases with elasticities

• The formula for DWL is

o and are the elasticity of supply and demand is the

Deadweight Loss and the Design of Efficient Tax

• Deadweight Loss and the Design of Efficient Tax Systems

Tax Policy Implications

• With many goods, the most efficient way to raise tax

• Spread taxes across all goods to keep tax rates

• Since marginal DWL rises with the tax rate, pre-existing

Progressive Tax Systems Can Be Less Efficient

No Tax Proportional Progressive

Tax rate below $10,000 0 20% 0%

Why is the deadweight loss larger for the higher-wage

Progressive Tax Systems Can Be Less Efficient

• The proportional tax is levied on a total of $30,000 of earnings.

• Government efficiency in taxation over time is maximized by tax

Optimal Commodity Taxation: Introduction

• Combine lessons on incidence and efficiency costs to analyze

• What is the best way to design taxes given equity and

Overview of Optimal Taxation

• From an efficiency perspective, would finance government

• Problem: cannot observe individuals’ types

Optimal Commodity Taxation

• We move from Positive question of how to measure

• James Mirrlees (1971) launched the second wave of optimal tax

• In the Mirrlees framework, the optimal tax problem

• Optimal commodity taxation: Choosing the tax rates

• MDWL is a positive function of the tax rate; higher taxes lead to

Inverse Elasticity Rule

Ramsey Formula: Limitations

• Ramsey solution: tax inelastic goods to minimize

• The rather abstract notions of optimal commodity taxation

• Most tax revenue in the developed countries is from income

1. Everyone in society has the same utility functions:

• With behavioral effects, taxes reduces hours worked.

• is MU for group , the marginal revenue, and is the

Optimal income taxation balances:

• So far we have ignored tax-benefit linkages.

0 L2 L3 L1 Quantity of labor (L)

• Why doesn’t the private sector provide these

• In the mid-1970s, states began to mandate insurance

• The fundamental issue in designing tax policy is the

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