Gruber4e ch20

Public Finance and Public Policy Jonathan
CopyrightGruber
2010 Fourth
WorthEdition
Publishers
Copyright 2012 Worth Publishers
1 of 40
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
P R E PAR E D B Y
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
2 of 40
20
C H AP T 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 L I C AT I O N S F O R O P T I M AL TAXAT I O N
Tax Inefficiencies and Their Implications for Optimal

Taxation
Usually, the market produces efficient
outcomes.
Taxes interfere in the market and reduce
efficiency.
People substitute away from the taxed
product, using less-efficient alternatives.
o Eight-person motorcycles in Indonesia
Some taxes have much larger efficiency
costs than others.
3 of 40
20.1
Taxation and Economic Efficiency: Graphical

Approach
S
Price per
gallon (P)
S
Tax =
$0.50
P2 =
$1.80
P1 =
$1.50
P3 =
$1.30
E
F
Deadweight
loss, DWL
D1
Q2 =
90
Q1 = 100
Quantity in
billions of
gallons (Q)
4 of 40
20.1
Taxation and Economic Efficiency
Absent taxes:
price = social marginal benefit = social
marginal cost
The tax drives a wedge between SMB and
SMC, preventing mutually beneficial trades
from occurring.
The units between 90 and 100 would have
generated a consumer and producer
surplus.
The foregone surplus from taxation is called
the deadweight loss (DWL).
The size of the DWL depends on elasticities.
5 of 40
20.1
Elasticities Determine Tax Inefficiency
Price per
gallon (P)
(a) Inelastic
demand
S
2
Tax
DWL
A
S
2
Tax
P2
P1
Price per
gallon (P)
(b) Elastic
demand
P2
P1
B
A
D
C
DWL
D
0
QQ
2
Quantity
in
billions
of
gallons
(Q)
Quantity in
billions of
gallons (Q)
6 of 40
20.1
Elasticities Determine Tax Inefficiency
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.
The more elastic is demand or supply, the
larger the DWL.
7 of 40
20.1
APPLICATION: Tax Avoidance in Practice
Keynes: The avoidance of taxes is the only

pursuit that still carries any reward. Some
examples of avoidance:
1. The Papal States taxed salt heavily, so
Tuscan bakers stopped using it. Even today,
Tuscan bread is saltless.
2. In the early 1980s, Cypruss building tax
applied to finished structures. Homeowners
put steel bars jutting out from their roofs to
avoid the tax.
3. Thailand taxes business signs on the
outside, with higher taxes for English-only
signs. So many signs have a bit of Thai
writing in the corner, or are hung on
Public Finance
and Public Policy
Jonathan Gruber
Edition Copyright 2012 Worth Publishers
curtains
inside
the Fourth
shop.
8 of 40
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.
9 of 40
20.1
Marginal DWL Rises with Tax Rate

Price
of gas
P3
Tax =
$0.10
S
2
P2
P1
Tax =
$0.10
DWL
C
E
D1
0
Q3
Q2
Q1
Quantity of
gas
10 of 40
20.1
A Tax Systems Efficiency Is Affected by a Markets

Preexisting Distortions
Since marginal DWL rises with the tax rate,
pre-existing distortions affect the efficiency
of a new tax.
o Preexisting distortions: Market
failures, such as externalities or
imperfect competition, that are in place
before any government intervention.
o Externalities Imperfect competition,
existing taxes.
11 of 40
20.1
A Tax Systems Efficiency Is Affected by a Markets

Preexisting Distortions
12 of 40
20.1
Progressive Tax Systems Can Be Less Efficient
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.
13 of 40
20.1
No
Tax
Proportio Progress
nal Tax
ive Tax
Tax rate below

$10,000
20%
0%
Tax rate above

$10,000
20%
60%
Low wage hours

Low wage DWL
1,000
0
864
$115.7
1,000
0
High wage hours

High wage DWL
Total DWL
1,000
0
0
864
$231.4
$347.1
837
$566.8
$566.8
14 of 40
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 highwage worker has a higher marginal product
of labor.
Society loses twice as much when the highwage worker reduces her hours than when
the low-wage worker reduces her hours.
15 of 40
20.1
Progressive Tax Systems Can Be Less Efficient:

Graphical Approach
16 of 40
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.
High-then-low tax rates produce a larger
DWL then steady medium tax rates.
17 of 40
20.1
APPLICATION: The Deadweight Loss of Taxing

Wireless Communications
Hausman (2000): The DWL from taxes on
wireless communications equals 53% of
revenue.
This figure is high for three reasons:
o High price sensitivity (elastic demand).
o Large pre-existing distortions from
imperfect competition.
o High taxes25% in some states, and in
those states, the DWL is even higher.
18 of 40
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: The value of having another
dollar in the governments hands relative to
19 of 40
20.2
Inverse Elasticity Rule
If supply is infinitely elastic, the Ramsey

Rule becomes:
o is the optimal tax, is the elasticity of

demand, and is some constant.
Optimal taxation therefore balances two
rules:
o Elasticity rule: Lower taxes on goods
with more elastic demand.
o Broad base rule: Better to tax a wide
variety of good moderately than few
goods heavily.
20 of 40
20.2
Equity Implications of the Ramsey Model
Imagine that the government had only two

goods it could tax, cereal and caviar:
Elasticity of demand for caviar is much
higher than that for cereal.
The inverse elasticity rule would suggest
that the government tax cereal much more
highly than caviar.
This means taxing the good consumed by
poor people more heavily.
This might hurt vertical equality.
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20.2
APPLICATION: Price Reform in Pakistan
Commodities are taxed or subsidized

throughout the developing world.
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
Oil/Fat
40%
5%
2.08
2.33
All
Poor
22 of 40
20.2
APPLICATION: Efficiency Consequences of Taxes

and Subsidies in Pakistan: Wheat (Inelastic Demand)
23 of 40
20.2
APPLICATION: Efficiency Consequences of

Subsidies in Pakistan: Wheat (Inelastic Demand)
24 of 40
20.2
APPLICATION: Efficiency Consequences of

Subsidies in Pakistan: Rice (Elastic Demand)
25 of 40
20.2
APPLICATION: Efficiency Consequences of Taxation

in Pakistan: Oils and Fats (Elastic Demand)
26 of 40
20.3
Optimal Income Taxes
Most tax revenue in the United States and

other 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.
27 of 40
20.3
A Simple Example
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:
28 of 40
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.
29 of 40
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
ofFourth
government
revenue.
Public Finance
and Public
Policy Jonathan
Gruber
Edition Copyright 2012
Worth Publishers
30 of 40
20.3
The Laffer Curve
31 of 40
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.
32 of 40
20.3
An Example: Optimal Income Taxes with Two Types
33 of 40
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.
34 of 40
20.4
Tax-Benefit Linkages: Graphical Representation

Wage
Taxes
S1 =
SMC
C
G
S2
W1
Benefits
F
W2
B
E
D2
0
L2
L3 L1
D1 =
SMB
Quantity of labor
(L)
35 of 40
20.4
Tax-Benefit Linkages: Graphical Representation
36 of 40
20.4
Perfect Linkage Eliminates the DWL
37 of 40
20.4
Issues Raised by Tax-Benefit Linkage Analysis
Why doesnt 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.
38 of 40
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.
39 of 40
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.
40 of 40

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Public Finance and Public Policy Jonathan

Tax Inefficiencies and Their

20.1 Taxation and Economic Efficiency

Tax Inefficiencies and Their Implications for Optimal

Taxation and Economic Efficiency: Graphical

Taxation and Economic Efficiency

Elasticities Determine Tax Inefficiency

Elasticities Determine Tax Inefficiency

Deadweight loss is caused by individuals

APPLICATION: Tax Avoidance in Practice

Keynes: The avoidance of taxes is the only

Determinants of Deadweight Loss

The formula for DWL is

o and are the elasticity of supply and

Marginal DWL Rises with Tax Rate

A Tax Systems Efficiency Is Affected by a Markets

A Tax Systems Efficiency Is Affected by a Markets

Progressive Tax Systems Can Be Less Efficient

Because the DWL rises with , progressive

Progressive Tax Systems Can Be Less Efficient

Tax rate below

Tax rate above

Low wage hours

High wage hours

Progressive Tax Systems Can Be Less Efficient

Why is the deadweight loss larger for the

Progressive Tax Systems Can Be Less Efficient:

Governments Should Smooth Tax Rates Over Time

Government efficiency in taxation over time

APPLICATION: The Deadweight Loss of Taxing

Ramsey Taxation: The Theory of Optimal

Optimal commodity taxation: Choosing

Inverse Elasticity Rule

If supply is infinitely elastic, the Ramsey

o is the optimal tax, is the elasticity of

Equity Implications of the Ramsey Model

Imagine that the government had only two

APPLICATION: Price Reform in Pakistan

Commodities are taxed or subsidized

APPLICATION: Efficiency Consequences of Taxes

APPLICATION: Efficiency Consequences of

APPLICATION: Efficiency Consequences of

APPLICATION: Efficiency Consequences of Taxation

Optimal Income Taxes

Most tax revenue in the United States and

Everyone in society has the same utility

Under these assumptions:

General Model with Behavioral Effects

With behavioral effects, taxes reduces

is MU for group , the marginal revenue,

The Laffer Curve

General Model with Behavioral Effects

Optimal income taxation balances:

An Example: Optimal Income Taxes with Two Types

Tax-Benefit Linkages and the Financing of Social

Tax-Benefit Linkages: Graphical Representation

Tax-Benefit Linkages: Graphical Representation

Perfect Linkage Eliminates the DWL

Issues Raised by Tax-Benefit Linkage Analysis

Why doesnt the private sector provide

EVIDENCE: A Group-Specific Employer Mandate

In the mid-1970s, states began to mandate

The fundamental issue in designing tax