Optimal tax

Optimal tax

Optimal tax theory is the study of how best to design a tax to minimize distortion and inefficiency subject to increasing set revenues through distortionary taxation.[1] A neutral tax is a theoretical tax which avoids distortion and inefficiency completely.[2][3]. Other things being equal, if a tax-payer must choose between two mutually exclusive economic projects (say investments) that have the same pre-tax risk and returns, the one with the lower tax or with a tax exemption would be chosen by a rational actor. Thus economists argue that taxes generally distort behavior.

For example, since only economic actors who engage in market activity of "entering the labor market" have an income tax liability on their wages, people who are able to consume leisure or engage in household production outside the market by say providing housewife services in lieu of hiring a maid are taxed more lightly. With the "married filing jointly" tax unit in U.S. income tax law, the second earner's income is added to the first wage earner's taxable income and thus gets the highest marginal rate. This type of tax creates a large distortion disfavoring women from the labor force during years when the couple have great child care needs.

The incidence of sales taxes on commodities also results in distortion if say food prepared in restaurants is taxed but supermarket-bought food prepared at home is not taxed at purchase. If a taxpayer needs to buy food at fast food restaurants because he/she is not wealthy enough to purchase extra leisure time (by working less) he/she pays the tax although a more prosperous person who enjoys playing at being a home chef is taxed more lightly. This differential taxation of commodities may cause inefficiency (by discouraging work in the market in favor of work in the household).

Ramsey (1927) developed a theory for optimal commodity sales taxes. The intersection on downward sloping demand curve and upward sloping supply curves implies that there is producer surplus and consumer surplus. Any sales tax reduces output and imposes a deadweight loss (DWL). If we assume nonvarying demand and supply elasticities, then a single uniform rate of tax on all commodities would seem to minimize the sum area of all such DWL triangles. Ramsey proposed that we assume suppliers were all perfectly elastic in their responses to price changes from tax and then concluded that taxes on goods with more inelastic consumer demand response would have smaller DWL distortions. Thus, we would tax MILK more than PAPAYA JUICE if consumers were more inelastic in their demand for cow’s milk. The DWL triangles are now termed Harberger triangles (for Arnold Harberger).

Modern theory of optimal taxation can be used to evaluate the efficiency of tax reforms in regard to marginal deadweight losses (Mayshar 1990, Slemrod & Yitzhaki 1996).


  • J. Mayshar (1990), "Measures of Excess Burden," Journal of Public Economics, 43, 263-289.
  • F.P. Ramsey (1927) "A Contribution to the Theory of Taxation," The Economic Journal, 37, no. 145, (March 1927), 47-61.
  • J. Slemrod and S. Yitzhaki (1996) "The costs of taxation and the marginal efficiency cost of funds," International Monetary Fund Staff Papers, March 1996, 43, 1
  • N.H. Stern (1987). "Optimal taxation," The New Palgrave: A Dictionary of Economics, v. 1, pp. 865-67.
  1. ^ Lars Ljungqvist and Thomas J. Sargent (2000), Recursive Macroeconomic Theory, 2nd ed, MIT Press, ISBN 0-262-19451-1, p.444.
  2. ^ Rothbard, Murray. (1970) Power and Market: Government and the Economy, p65
  3. ^ Business Dictionary.com

See also

Wikimedia Foundation. 2010.

Look at other dictionaries:

  • Tax exporting — occurs when a country (or other jurisdiction) encourages economic activity to move to another country (or jurisdiction) because its taxes are too high. This is more likely if the economic activity is more mobile.For example, land is not mobile,… …   Wikipedia

  • Tax — Taxation An aspect of fiscal policy …   Wikipedia

  • Tax rate — For a type of taxation system in the United Kingdom and elsewhere, see Rates (tax). Taxation An aspect of fiscal policy …   Wikipedia

  • Tax noncompliance — Taxation An aspect of fiscal policy …   Wikipedia

  • Tax deduction — This article is about the deduction of expenses for the purpose of calculating taxable income. For tax deducted at source, see Withholding tax. Taxation An aspect of fiscal policy …   Wikipedia

  • Tax treaty — Taxation An aspect of fiscal policy …   Wikipedia

  • Tax rates around the world — Taxation An aspect of fiscal policy …   Wikipedia

  • Optimal Capital Structure — The best debt to equity ratio for a firm that maximizes its value. The optimal capital structure for a company is one which offers a balance between the ideal debt to equity range and minimizes the firm s cost of capital. In theory, debt… …   Investment dictionary

  • Progressive tax — A progressive tax is a tax imposed so that the tax rate increases as the amount subject to taxation increases. [ [http://www.merriam webster.com/dictionary/Progressive Webster] (4b): increasing in rate as the base increases (a progressive tax)] [ …   Wikipedia

  • Dividend tax — Taxation An aspect of fiscal policy …   Wikipedia

Share the article and excerpts

Direct link
Do a right-click on the link above
and select “Copy Link”