Journal of Public Economics 6 (1976) 37-54.

0 North-Holland Publishing Company

OPTIMAL TAXATION
An introduction to the literature

Agnar SANDMO*
Norwegian School of Economics and Business Administration, Bergen, Norway

Revised version received September 1975

This paper attempts to give an introductory survey of recent contributions to the literature on
optimal taxation. It covers the basic theorems on optimal commodity taxation and discusses
the insights that the theory provides into the structure of an optimal tax system. No systematic
study is made of the possibilities for application, but the theory is surveyed with a view towards
its implications for actual tax policy.

1. Introduction
Among a subset of economists the term ‘optimal taxation’ has come to acquire
a meaning which is not obvious to economists who have not been following
modern developments in public finance and welfare economics. Clearly, one
could think of at least three different criteria for ‘optimality’ of the tax system.
First, one could argue that a good tax system is one which minimizes the
resource cost involved in assessing, collecting and paying the taxes. This is
frequently a rather dominant concern of tax administrators, although they
typically emphasize the costs incurred by the tax collectors and tend to neglect
those borne by the firms and consumers who pay the taxes. Second, one could
evaluate alternative tax systems in terms of justice or fairness. This would seem
to be the line of thought which it is most natural for the ordinary taxpayer to
follow, although his concept of justice may not be very precise and may include
considerations which the economist would prefer to group under a different
heading. Third, tax systems can be ranked according to the criterion of economic
efficiency, and this was the original point of departure for the economic theory
of optimal taxation; the optimal tax system is the one which minimizes the
aggregate deadweight loss for any given tax revenue or level of public expenditure.
The theory has then gradually been extended to take account of distributional
*This paper was presented to the Conference on the Economics of Taxation, sponsored by
the International Seminar in Public Economics, which was held at the Abbaye de Royaumont,
France, January IS-20,1975. I appreciate the helpful comments received by the participants in
the seminar, in particular Peter Diamond, Martin Feldstein and Serge-Christophe Kohn,
and by Tony Atkiin, Arne Gabrieken and Victor Norman.
38 A. Sandmo, Optimal taxation

considerations. As regards the costs of administration, these have so far not been
satisfactorily integrated in the theory, which of course to some extent limits its
relevance for discussions of actual tax policy and tax reform.
From an efficiency point of view an ideal tax system is one which is consistent
with a Pareto optimal allocation of resources. The classical solution to the
problem is to advocate lump-sum taxes, which are clearly neutral with respect
to all marginal evaluations made by consumers and producers, but this is not a
very helpful conclusion for the public finance economist. Although lump-sum
taxes can be envisaged in the context of a once-and-for-all levy, it is much more
difficult to imagine such taxes as a permanent system. If the public sector levies
lump-sum taxes each year in such a way that the elasticity of the tax payment
with respect to the taxpayer’s income exceeds one everywhere, taxpayers will
soon discover that they do in fact have a progressive income tax system and
adjust their actions accordingly. Therefore, it is hard to resist the conclusion
that lump-sum taxation is a bad assumption both from a descriptive and a
normative point of view.
However, even if lump-sum taxes are ruled out, there are still taxes which are
consistent with Pareto optimality. There is for example a large literature on the
conditions under which a profits tax will be neutral with respect to production and
investment decisions. Moreover, it has been argued since Pigou (1920) that
indirect taxes can be used to improve the efficiency of the market allocation of
resources in the presence of externalities. Thus, taxation need not be distortionary
by the standard of Pareto optimality. But it seems definitely sensible to admit the
unrealism of the assumption that the public sector can raise all its tax revenue
from neutral or Pigovian taxes, and once we admit this we face the second-best
problem of making the best of a necessarily distortionary tax system. This is the
problem with which the optimal tax literature is mainly concerned.
The treatment of the problem in the literature has an interesting and rather
curious history. This has been well described by Baumol and Bradford (1970),
so that there is no reason to go into details here. Although the early history of
the subject goes back at least to 19th century writers on public utilities, the tist
analytical formulation and solution of the problem appears in the celebrated
article by Ramsey (1927). Ramsey gives credit to Pigou for suggesting the
problem, and Pigou himself gave a very good, although simplified, treatment
of it in his book on public iinance (1947). In spite of its exposure to the profession
the analysis seems to have fallen into oblivion for many years.’ It was hardly
mentioned in textbooks on public finance, nor did it have any impact on the
analysis of the welfare economics of the second best which began with the article
by Lipsey and Lancaster (1956-57); in fact, these authors do not even refer to

‘However,note should be made of the paper by Samuelson (1951), which is unfortunately

still unpublished, and of Corlett and Hague (1953-54). whose important pioneering contribution
is discussed in section 4 below.
 A. Sandmo, Optimal taxation 39

the Ramsey-Pigou analysis.? Among French economists the subject received

more attention; important analysis was contributed by Boiteux (1951, 1956) and
many further developments were made by Kahn (1969, 1970). 3 Around 1970
there began a general revival of interest in the subject, with publication of articles
by Baumol and Bradford (1970), Lerner (1970), Dixit (1970) and Diamond and
Mirrlees (1971); of these, the Diamond-Mirrlees article in particular represents
a major generalization and extension of the Ramsey formulation. The field now
seems well established as one of considerable interest both from a theoretical
and a practical point of view, and future textbooks in public economics will
surely come to devote space to it both in their chapters on taxation and on public
utility pricing.
The present paper attempts to provide an introductory survey of the field
which is intelligible to the nonspecialist, and at the same time to evaluate the
relevance of the theoretical results for economic policy in the field of taxation.
This is quite a lot for one paper, and the treatment is necessarily incomplete
in many respects. Of the analytical detail, only the minimum which is necessary
to gain some real insight into the subject is presented, and the discussion of policy
implications are also rather sketchy and unsystematic.
Section 2 introduces the basic theory of optimal commodity taxation. Section 3
analyzes the question of the possible uniformity of the optimal tax structure,
and section 4 presents some formulas for simplified cases. The discussion is
extended in section 5 to take account of production and supply conditions and
in section 6 to incorporate redistributional objectives of taxation. Section 7
discusses briefly some additional problems in commodity taxation that are
raised by public goods, externalities, international trade, public utilities and by
the introduction of income taxes. The final section is an attempt to evaluate
briefly the contribution that the optimal tax literature has made so far to the
practical aspects of public economics.
The paper attempts mainly to give an introductory survey of the field rather
than of the literature itself, and it is therefore inevitable, although regrettable,
that some important contributions have gone unmentioned: a more complete
coverage of the literature would necessarily have implied less attention to
analytical detail.

2. Optimal commodity taxation: The simplest case

We shall start with the very simplest model imaginable, given that the inherent
complexities of the problem are not entirely to be lost. Suppose that there are
ZThe analytical approach of Lipsey and Lancaster may have prevented them from discover-
ing the similarity between their theory and that of Ramsey and Boiteux. In fact, there can be
shown to exist a duality relationship between the two sets of formulations; this has been studied
in detail by Bronsard (1971).
3These contributions have later been incorporated into Kolm’s treatise on pubhc economics
(1971a,b).
40 A. Sandmo, Optimal taxation

m + 1 commodities in the economy, the first of which is labour (to be denoted

commodity 0) and the remaining m commodities are consumer goods. The
latter are subject to indirect taxation, and we imagine that the public sector has
a fixed tax revenue constraint, which says that a given amount - expressed in
units of labour, which serves as the numeraire - has to be collected in taxes.
Letting I, be the tax on commodity i and xi its quantity, we can write this
constraint as

~ t,Xi = T, (1)
i=l

where ti is defined as the difference between the price paid by the consumer (Pi)
and that which is received by the producer (pi). Let us assume that producer
prices are given; this assumption has been shown to be equivalent in terms of its
implications to the more general assumption of constant returns to scale. This
then means that the problem of selecting a tax structure is equivalent to choosing
a structure of consumer prices. We now make the further drastically simplifying
assumption that the consumer side of the economy can be treated as if there were
only one consumer. Taken literally, this assumption is of course quite uninterest-
ing, so we need to be careful about the possible economic interpretation of this
‘as if’ assumption. We shall return to this question later on. For the moment we
just postulate the existence of a social utility function,

u = wo, Xl,. * ., x,), (2)

satisfying the usual concavity properties of consumer theory. Our problem is
then to choose a tax structure (tI, . . ., t,) - or, equivalently, a consumer price
structure (PI, . . ., I’,,,) -which satisfies (1) and maximizes (2) subject to this
constraint. We can formulate this problem in terms of a Lagrange function,

L = lJ(XO,Xl,. . ., X”)+P(i~~iX’T) 3

and we obtain the necessary conditions for a constrained maximum of U by

setting the partial derivatives of L with respect to the tax rates equal to zero4 :

~o~-~+p(~;i~+xk)=O,
k= l,...,m.

These conditions can be simplified once we take account of the optimizing

4Note that Xx,/W, = ax&t,. It is convenientto write the derivativesof demand functions
in terms of pricesrather than as functionsof the taxes.
 A. Sandmo, Optimal taxation 41

behaviour of consumers, who maximize the utility function (2) subject to the
budget constraint

(5)

This way of writing the budget constraint is easy to understand if we think of

labour supply as being measured negatively; (5) then says simply that earnings
must be equal to expenditure. Note in particular that there is no exogenous
income which is not related to factor supply, nor are there any lump-sum taxes
or subsidies. The optimum conditions for consumers take the form

Ui_APi= 0, i = 0, 1, . . ., m, (6)

where Ui = au/&, . Substituting from (6) into (4) we obtain

A f p."'+p f t.%+, = 0,
k = 1,. . ., m. (4’)
i=* ‘apk t-1 ‘apk

But from the budget constraint (5) we have that

f
i=O
piz+Xk
= 0,

so that (4’) can be written as

5 t axi
-2x,+/d
( i=l i&+Xk
>
=Os

and finally as

Condition (7) provides the starting point for a discussion of what kind of rules
for commodity taxation can be derived from the analysis. The first such rule is
the one first derived by Ramsey (1927). Since we can write the Slutsky equation as

ax,
-= --_x, $if Sik, i, k = 1, . . ., m,
apk
42 A. Sandmo, Optimal taxation

where I is income 5 and sik is the substitution effect, we can substitute from this
into (7) to obtain

We can now utilize the fact that the substitution effects are symmetric (i.e.
Sik = ski) to rewrite the condition as

xk=v+ f t ivy
fEl
ax, k= l,..., m.

The left-hand side of this equation can be interpreted as the relative decrease
in demand for commodity k following on the tax change, provided that the
consumer is compensated so as to stay on the same indifference curve. Since the
right-hand side is constant, i.e. independent of k, it follows that this proportionate
reduction of demand should be the same for all commodities.6
This result is particularly valuable when contrasted with the idea that indirect
taxation at uniform rates is obviously best from an efficiency point of view.
The uniformity issue will be discussed later, but it is well to remind the reader at
this stage that an optimal allocation is defined in terms of quantities, not in terms
of prices, and that a proportional reduction of all prices in terms of the numeraire
has no obvious claim to be considered as optimal.
Nevertheless, the Ramsey rule is hardly of great significance as a guide to
practical tax policy. As it stands, it is valid only for an arbitrarily small tax
revenue. Going back to eq. (7), we see easily that we could have a different and
more interesting version of the Ramsey result if it were true that

axi axk
i, k = 1, ...,m;
api
-=-)

ap,

for we could then rewrite (7) as

(i$ti~)/xk=v~ k= l,...,m, (11)

5Actually, there is no exogenously given income in this model. This does not prevent us
from utilizing the Slutsky equation, however, for we are simply using the income derivative to
characterize the consumption indifference map.
6 -p is the marginal social value of an increase in T. Since this is negative, no account being
taken in the present model of the uses of T, it follows that I( > 0. It can be shown that for
T > 0, we must have Y = (d-p)/@ < 0. Intuitively this means that if consumers were to be
given an exogenous (lump-sum) increase in income, and if this amount were then to be taxed
away from them by means of indirect taxation, they would suffer a net loss. This is of course
another restatement of the superiority of lump-sum taxation.
 A. Sandmo, Optimal taxation 43

which implies that the Ramsey result of uniform proportional reduction of

demand would be true without the restrictive assumption of zero tax revenue.
Then question then becomes: when is (10) true? Going back to the Slutsky
equation (8), and taking account of the symmetry of the substitution effects,
we see that (10) implies

I ax, z ax,
-*-
xl az
- -*-3
X, az
i, k = 1, . . ., m,

i.e. equal income elasticities for all taxed goods.

Fig. 1

This can be illustrated diagrammatically for the case of two taxed goods
(fig. I).’ The indifference map for the two taxed goods is homothetic, and the
fall in demand resulting from taxation should be along the line OQ of equal
proportionate reduction. Note that this also implies uniform taxation, i.e. no
change of relative prices within the group of taxed goods.
This suggests that deviations from the rule of uniform proportional reduction
must be sought in unequal elasticities of income, and an interesting result to this
effect can in fact be derived. From (8) and the symmetry of the substitution
?The reader is warned that the diagram must be interpreted with more than usual care, since
it does not adequately take into account the existence of the third commodity, labour, which is
the numeraire good.
44 A. Sandmo, Optimal taxation

terms we have that

ax, ax,
-z
ax, ax;
ap, aP,+xi ZDXk ;iT*
Substituting into (7) and rearranging terms, we obtain

If the proportionate change in demand for commodity k resulting from a

hypothetical change in exogeneous income is higher on the average (using tax
payments as weights) than for the other taxed commodities, then this implies a
larger than average proportionate reduction of demand.
This result lends itself nicely to an intuitive interpretation. Tax increases have
both income and substitution effects, and the income effects are analogous to
the changes that would have resulted if the revenue had been raised by lump-sum
taxes. Since the latter effects are nondistortionary, so are the pure income effects
and we should therefore reduce the demand most for the commodities where
these effects dominate.

3. The uniformity issue

We have already remarked that the rule of uniform taxation - i.e. taxation of
all commodities at equal percentage rates - has no obvious claim to optimality.
Yet in the example shown in fig. 1 above, this rule did after all turn out to be
optimal. It is certainly of great interest both theoretically and practically to study
the conditions under which this result holds.’
One might perhaps think that if only the set of taxable commodities were
extended so as to include labour, then uniform taxation would turn out to be
optimal, since this would mean that no relative prices in the system would be
changed, as compared with the pre-tax Pareto optimal equilibrium. But this is
wrong, for the simple reason that such a tax structure would result in zero tax
revenue. Let Bi = ti/Pi, i.e. the tax rate as a percentage of the consumer price.
Total tax revenue is then

T= F t$Pixi = 0 i=O
i=O
f Pixi,

where the last equality follows from the uniformity assumption. But from the

*This section is based on Sandmo (1974); see also Atkinson and Stiglitz (1972).
 A. Sandmo, Optimal taxation 45

budget constraint (5) this expression is necessarily zero. Keeping all relative
prices constant when consumer goods are taxed implies subsidizing labour
supply at the same rate, and subsidies and taxes must necessarily cancel each
other. The possible optimality of uniform taxation cannot be established in this
way.
It has long been realized that if there exists a commodity which is completely
inelastic in demand, not only with respect to its own but to all prices, then this
commodity is an ideal object of taxation from an efficiency point of view.
Suppose now that labour is completely inelastic in supply. Ideally, we would have
liked to choose labour as the only taxed commodity; this would have meant a
change in the relative price of labour and consumer goods, but no change in the
relative prices among the consumer goods themselves. It then becomes clear that
if labour is not taxed, we can achieve exactly the same result by taxing all con-
sumer goods at the same rate, so that this is a case where uniform taxation is
optimal.
The other case in which uniform consumer goods taxation is optimal can be
identified by referring again to fig. 1. Here uniform taxation is optimal because
the income elasticities for both taxed goods are the same; the indifference map
is homothetic. However, the argument is incomplete because the indifference
map must be understood as drawn for a given supply of labour, while this
supply will in reality change with the structure of prices. But if the indifference
map is in effect invariant with respect to changes in the labour supply, the
argument obviously holds. This implies that we have to add an assumption of
utility separability between consumption and labour to that of homotheticity in
the consumption indifference map; under these conditions we have again that
uniform taxation is optimal
Thus, although there do exist interesting cases in which uniform taxation is
optimal, these must definitely be considered as exceptions. In the general case it is
not easy to see the structure of taxation which follows from the general
optimality conditions. There are some special cases, however, in which this is
possible, and to these we now turn.

4. Elasticity formulae
Let us assume that all cross derivatives of the demand functions vanish as
between the taxed goods. Conditions (7) are then simplified to read

k= l,...,m,

where &,& is the (direct) price elasticity of demand. This is the well-known inverse
elasticity rule, which has also been derived from partial consumer surplus
46 A. Sanaho, Optimal taxation

analysis, e.g. by Hicks (1947). The idea behind the rule of imposing the highest
tax rates on the commodities with the lowest price elasticities of demand is of
course to minimize the deviations from the nondistortive, pre-tax allocation.
Elasticity formulae become very complicated in the general case and provide
little intuitive insight into the structure of taxation. One particular case which it
may be useful to consider is a three-good model, containing labour and two
taxed goods, This case was first considered by Corlett and Hague (1953-54).’
Eq. (9) then becomes

@ll +t,s12 = - KXl,

t,s,,+t2s,* = - KX2.

Here we have written K for the right-hand side of (9). These equations can be
solved to yield
Xl sz2 - X2Sl2
t, = --K >
S11S22-3 :2

X2%1 -x1s21
t2= --Ic
SllS22 42

We can rewrite these expressions in terms of ad valorem tax rates and com-
pensated elasticities as follows :

1 x1x2
8, = --K (c722-(712) = -G~22--%2h
w22-~:2plpz

1
o2 = -K =%rri -cr21) = - K’(cQi-02J.
W22-42PlP2

Here the compensated elasticity uki = Ski(PI/Xk)(i, k, = 1,2). It follows from

the theory of consumption that sllsz 2 - sf2 > 0. It also follows that

~lo+~li+~lz = 0 = cr2,+cr21+a22.

Substituting for crl2 and a,, in the expressions for the tax rates, we obtain

4 = -“‘(“11+a,,+o,fJ, (14)

02 = --‘tfJ,l+~22+Q20), (15)
9An early and apparently neglected reference is Meade (1955). The model has also been
studied by Diamond and Mirrlees (1971, part II) and by Andersen (1971).
 A. Sandmo, Optimal taxation 41

and it follows that

The consumer good which is to be taxed at the highest rate is the one with the
lowest compensated cross-elasticity with labour. This implies that a consumer
good which is a complement with iabour (substitute for leisure) should be taxed
at a lower rate than one which is a substitute for labour (complementary with
leisure). The economic rationale of this rule is clearly that since we have barred
ourselves from taxing leisure, we can do it indirectly by taxing the commodities
that are complementary with leisure.

5. Production and supply

Our assumption of given producer prices has led us to rules of optimal taxa-
tion which are independent of the conditions of production and supply. It was
shown by Diamond and Mirrlees (1971) that these rules continue to be valid in
the more general case of constant returns to scale. This is an important result
which may not be intuitively obvious, since marginal cost under constant returns
is constant only in a partial equilibrium and not in a general equilibrium sense.
However, this raises the question of how the rules will have to be changed in the
case of nonconstant returns to scale. We shall focus here on the case of decreasing
returns, since increasing returns to scale raises some particularly difficult
questions which it would be impossible to discuss at all adequately in the present
context.
Analytically, the most direct and easy approach to this issue is just to add a
production constraint to our maximization problem. Derivatives of the supply
functions will then enter the optimal tax formulae along with the demand
derivatives. This does not, of course, make the tax structure any easier to
evaluate than before, and to get some feeling for the implications of the analysis
we have to consider special cases. If we make the assumption that all cross-
elasticities of both demand and supply functions vanish, it can be shown that,
as an approximation, the optimal tax rate for any one commodity is proportional
to the sum of the inverses of the demand and supply elasticities; this is an
extension of our previous rule (13). It can be left to the reader as an exercise to
extend our previous analyses to the case of production along these lines; this has
also been done by Dixit (1970).
However, this approach raises some awkward questions. How can we work
with an aggregate production constraint if there are decreasing returns to scale?
And if we disaggregate the model to the level of the individual firm, does not
this open up the possibility that firms should be taxed at different rates? The
latter result obviously implies production inefficiency, i.e. a movement away from
48 A. Sam&no, Optimal taxation

the production possibility curve, but in a second-best world it clearly cannot be

ruled out. One should also take into account that with decreasing returns, profits
will exist in general equilibrium, and that one should therefore consider profit
taxes as components of an optimal tax structure.
By our assumption of given producer prices equal to marginal costs, we have
in fact assumed productive efficiency. Assuming constant returns to scale,
Diamond and Mirrlees (1971) showed that productive efficiency was indeed
desirable. The argument is very simple and is presented particularly clearly in
Mirrlees (1972). The essential point turns out to be that consumer welfare does
not depend directly on producer prices; it is then optimal for producers to
maximize profit at prices that imply production efficiency, which again implies
that they must face the same price vector. It was brought out by Stiglitz and
Dasgupta (1971) that the important assumption here is not that of constant
returns per se but of zero profits in equilibrium. Thus, they showed that the
desirability of productive efficiency continues to hold under decreasing returns
to scale, provided that the government imposes a 100 percent profits tax on all
producers.
We shall not go any further into this line of argument, which easily becomes
quite involved. However, we note that with the possibility of differential taxation
of producers we must also take into account that producers may find it profitable
to merge or dissolve firms for tax reasons. This might make it both difficult and
costly to operate such a tax system and is presumably one of the reasons why,
for example, the corporate profits tax is almost always a genera1 proportional
tax. Perhaps, therefore, one should not worry too much about the exceptions to
the rule that productive efficiency is desirable; the administrative and informa-
tional costs of deviating from the rule might easily be too high for it to be an
interesting alternative.

6. Distributional considerations
So far we have been assuming a one-consumer economy, or, alternatively,
that the preferences of the community can be represented by social indifference
curves. This can evidently only be a first approximation. Social indifference
curves exist if lump-sum transfers are constantly being used ‘in the background’
to keep the income distribution optimal according to some individualistic
welfare function; but in the optimal tax literature such transfers are ruled out
by assumption. Social indifference curves also exist if all individuals have identical
and homothetic indifference maps; but in that case we can safely ignore distribu-
tional issues, since nothing in the way of redistribution can be achieved by
commodity taxation anyway.l’
“‘For a fuller discussion of social indifference curves, see Samuelson (1956).
 A. Sandmo, Optimal taxation 49

The possibility of a conflict between our efficiency rules and distributional

objectives becomes evident when we consider the practical implications of the
inverse elasticity rule. We tend to think of commodities with numerically low
price elasticities as being necessities, and of those with high elasticities as luxuries.
The rule then implies that necessities should be taxed at higher rates than luxuries.
Atkinson and Stiglitz (1972) have performed some illustrative calculations on
empirical data which confirm this ; they come out with tax rates on food which
are two to three times higher than those on consumer durables. There is clearly
a need for a modification of the analysis to give some scope for distributional
considerations.
Let us now assume that individuals are heterogenous both with respect to
preferences and productivities. The utility function of individual j is

Uj = Uj(XjO, . . .) Xj,), j = 1,. . ., n, (17)

and the welfare function, which is assumed to belong to the individualistic

Bergson-Samuelson family, is

w= W(u,, . . ., u,), wj > 0. (18)

We can now obtain a generalization of the analysis in section 2 by maximizing
(18) with respect to consumer prices subject to the government’s budget con-
straint. There is no need to go through the whole analysis again and we shall
just give the main result for the case of independent demands,‘l in which we
obtain a generalization of the inverse elasticity formula:

The ad valorem tax rate is still proportional to the inverse of the market
demand elasticity, but the proportionality factor has a more complicated form.
Given the market demand elasticity, the tax rate on good k should be higher, the
lower is consumers’ average social marginal utility of income, when weighted
by their consumption of good k. In the special case where all individuals have
the same strictly concave utility function and the welfare function is the un-
weighted sum of individual utilities, we can draw the stronger conclusion that
“It may be worth noting that to derive the generalized inverse elasticity formula, it is only
necessary to assume that the cross-derivatives of the market demand functions vanish.
Theoretically at least, one could imagine cases where two commodities are substitutes for some
consumers and complements for others, with zero cross-effect in the aggregate, so that this
assumption is weaker than that of demand independence for all consumers.
50 A. Sat&no, Optimal taxation

the tax rate should be higher, the more strongly the consumption of the com-
modity is concentrated among high-income individuals.’ 2
It is of course difficult to claim much in the way of immediate applicability
for the formula (19) and for the more general conditions for optimal taxation in
the case of many individuals. What we may claim for the analysis seems mainly
to be that it gives some insights into the nature of the compromise between
equity and efficiency considerations that will have to be made in practice. These
insights are not so general as to be empty of all empirical content. One may note
that if two goods have the same proportionality factor-if, in the words of
Feldstein (1972a), they have the same distributional characteristic - then it is
still true, in the case of independent demands, that the ratio of their tax rates
should be equal to the inverse ratio of their price elasticities. One might also
attempt to develop the distributional characteristic into a more operational
measure; this is also done by Feldstein (1972a,b).

7. Further problems in commodity taxation

With the recent growth of the literature on optimal taxation, the grounds for
considering it as a special field within the general area of public economics are
weakening. This is not only because an increasing number of economists are
becoming familiar with this type of analysis, but also because the theory is
rapidly becoming integrated with other well-established subfields of public
economics and general economic analysis. It is obviously impossible here to go
into all of these in any detail, but they should at least be mentioned.

(I) Public goods and taxes. It was argued by Pigou (1947) that distortionary
taxation introduces an additional cost factor in calculations of the optimal supply
of public goods. Consequently, he argued, one would want to curtail the supply
of public goods compared to the first-best rule of making marginal benefit equal
to marginal cost. This conclusion has been analyzed in the contributions of
Stiglitz and Dasgupta (1971) and Atkinson and Stern (1974). Their work
represents a generalization of the analysis of previous sections, in that the public
sector’s tax revenue requirement is derived from the cost of supplying public
goods. It turns out that Pigou’s conjecture is not generally correct. Under first-
best conditions, the correct benefit measure, assuming an optimal distribution of
income, is the sum of the marginal rates of substitution. With distortionary
taxation, the correct benefit measure may exceed the first-best measure if the
public good is complementary with taxed goods or if taxation releases income
effects which increase the demand for the taxed goods; the latter case would be
of importance if taxed goods are inferior. Atkinson and Stern also point out

1*A more generaltreatment of distributionalissues,attemptingto generalizethe Ramseyrule

(9) is contained in the articles by Mirrks (1975) and Diamond (1975).
 A. Sam&no, Optimal taxation 51

that the answer to the question of the correct benefit measure does not in itself
provide a solution to the over- or under-supply problem. This is more difficult,
and there does not seem to be available a simple and general solution.

(2) Externalities. If externalities exist we know that taxes and subsidies can
be used to improve the competitive allocation of resources and in fact make it
Pareto optimal. However, the standard analysis of Pigovian taxes assumes, more
or less implicitly, that the public sector either needs no additional tax revenue or
that it distributes the proceeds from Pigovian taxes in a lump-sum manner.
If neither of these conditions hold, we again have a second-best problem where
the government must simultaneously employ taxes which improve and taxes
which distort the allocation of resources. Sandmo (1975) analyzes the optimal
combination of such taxes for the case of a negative consumption externality
and concludes that the marginal social damage should only be reflected in the
tax on the externality-creating commodity, regardless of the pattern of comple-
mentarity and substitutability; exceptions to this rule have been discussed by
Green and Sheshinski (1974).
Another issue in this area concerns the choice of optimal taxes or subsidies
when the government is constrained to tax uniformly generators of externalities
whom it really would have been optimal to tax at different rates. This problem
has been investigated by Kolm (1971b) and Diamond (1973).

(3) International trade. The theory of the optimal tariff has some important
similarities with the theory of optimal commodity taxation, and it seems a
natural undertaking to try to integrate the two bodies of literature. This has
been attempted in articles by Boadway, Maital and Prachowny (1973) and
Dasgupta and Stiglitz (1974). The problem here has some similarities with one
which arises in the analysis of externalities; we wish to derive rules for optimal
tariffs (which improve the allocation of resources) and optimal commodity
taxes (which distort it) simultaneously. The two articles also discuss optimality
criteria for public goods and relate the criteria to the problem of the use of
international prices in domestic cost-benefit analyses.r3

(4) Public utility pricing. The theory of optimal commodity taxation can be
reinterpreted as a theory of public utility pricing, and the latter furnishes the
frame of reference for many contributions to the subject; in particular, this is
true of the work of French economists like Boiteux (1956) and Kolm (1971a, b).
This interpretation is perhaps a more natural one as long as economic efficiency
is taken as the sole criterion; one could imagine the government as ordering
public utilities to set their prices according to efficiency criteria on the assump-

IsFor an application of optimal tax theory to the problems of international economic

integration, see Kolm (1969b).
52 A. Sandmo, Optimal taxation

tion that the government itself will determine appropriate redistributional

policies.

(5) Income taxation. Many of the ideas discussed so far are of course
applicable to income taxation as well as to commodity taxation. Thus, we should
expect the efficiency loss associated with an income tax to be larger the more
elastic is the labour supply with respect to the wage rate. If we consider the
degree of progression in the tax schedule, it would obviously be important to
know how the elasticity of labour supply varies with income. If people with
higher income are also characterized by elastic labour supply, this would act as
a brake on the degree of progression that one might otherwise prefer from a
redistributional point of view. Nevertheless, income taxation has some peculiar
features which are difficult to incorporate in the previous framework. Space
prevents a full treatment of this topic here; the reader is referred to the articles
by Mirrlees (1971) and Sheshinski (1972) as well as to the survey in Atkinson
(1973).

8. Concludiug remarks

There can be no doubt that the recent developments in the analysis of optimal
taxation have brought welfare economics closer to the realities of economic
policy. We know how to model optimization problems in the public sector with
fairly realistic assumptions about the set of policy tools available. New insights
have been gained into the efficiency aspects of taxation, and we can probably
also claim to have obtained a better understanding of the tradeoff between
equity and efficiency.
The theory obviously has its limitations. It is at its best in yielding rules for
the optimal structuring of a given tax system and has less to contribute to the
discussion of major problems of tax reform, which typically involves the choice
between alternative tax systems. A difficulty with the extension of the theory to
cover these ‘global’ problems is that the costs of administration have not been
incorporated into the theory;i4 this is one aspect of the neglect of transactions
costs in the theory of general equilibrium. The incorporation of costs of adminis-
tration is an extremely complicated task, and it remains to be seen whether a
formally more complete theory can still yield conclusions which are interesting
and meaningful from the point of view of implementation.
However, this raises the question of whether optimum tax formulae can have
any claim to be taken seriously, given that they abstract from such central
concerns as administrative costs and incomplete information.’ ’ Whatever the

14An attempt to do so is presented by Heller and Shell (1974). However, this work is still at a
very abstract level.
15For an answer which is mainly in the negative, see Hahn (1973).
 A. Sadno, Optimal taxation 53

final answer to this question may be, I believe that we shall probably have to
reconcile ourselves to the fact that no policy model can be complete in the sense
of taking account of all relevant concerns facing a policymaker. Thus, it may well
be that we shall find the models of optimal taxation to be useful ones, even
though we may have to supplement them with considerations which are
exogenous to the models themselves.

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