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NPTEL-Economics-Public Economics

Module 10
OPTIMAL TAXATION
Lecture (34 - 37)
Topics

10.1 Tax Inefficiencies and Their Implications for Optimal


Taxation
10.2 Optimal Taxation: Introduction
10.3 Efficiency Cost: Properties
10.4 Efficiency Cost: Property 1
10.5 Elasticities Determine Tax Inefficiency
10.6 Efficiency Cost: Property 2
10.7 Measuring Excess Burden
10.8 Tax on Consumers
10.9 Taxation and Economic Efficiency: Policy Implications
10.10 Tax Avoidance in Practice
10.11 Conceptual Problems in Measuring Surplus
10.12 Expenditure Function
10.13 Compensating Vs. Equivalent Variations
10.14 Compensating Variations
10.15 Equivalent Variations
10.16 Excess Burden Using CV and EV
1
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

10.17 Tax Burden: Extensions


10.18 Preexisting Distortions
10.19 Proportional Vs. Progressive Tax
10.20 Tax Smoothing
10.21 Optimal Commodity Taxation
10.22 Optimal Tax Theory: Ramsey Rule
10.23 Ramsey Model
10.24 Ramsey Rule to Inverse Elasticity Rule
10.25 Ramsey Rule: Application
10.26 Optimal Income Taxation
10.27 Optimal Income Taxes: Behavioral Effects
10.28 Laffer Curve
10.29 Optimal Income Taxes

2
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

Module
Lecture 34
Topics
10.1 TAX INEFFICIENCIES AND THEIR IMPLICATIONS
FOR OPTIMAL TAXATION
Focus in incidence analysis is on prices, not quantities
Incidence analysis: effect of policies on distribution of economic pie
Focus in efficiency analysis is on quantities, not prices
Efficiency or deadweight loss: effect of policies on size of the pie.

10.2 OPTIMAL TAXATION: INTRODUCTION


Government raises taxes for one of two reasons:
To raise revenue to finance public goods
To redistribute income
But to generate Re1 of revenue, welfare of those taxed might be reduced by more
than Re1 because the tax distorts incentives and behaviour
Producers and consumers can undertake actions in response to a tax to
minimize their burden. This in turn will have efficiency costs for the
society.
Example: Harbeger saw in Indonesia
taxi/buses on 3 wheels.
Converting motorcycles to taxi instead of 4 wheel tax is higher on four
wheels. Bad for the society 3-wheelers are unsafe.
How to implement policies that minimize these efficiency costs
A basic optimal taxation framework enables as to measure the efficiency cost of a
given tax system
This basic framework for optimal taxation is also used for studying advanced
applications: transfer programs, social insurance, etc.

3
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

Figure 34.1
Consider the impact of a per liter tax on the suppliers of diesel.
Initial equilibrium at A:
Tax on diesel shifts the supply curve up.
BC is the rift between SMB and SMC due to the tax.
Tax creates a Dead weight loss = ABC.
.

10.3 EFFICIENCY COST: PROPERTIES


Excess burden increases with elasticities.
Excess burden increases with square of tax rate.

10.4 EFFICIENCY COST: PROPERTY 1


The efficiency consequences would be identical regardless of which side of the
market the tax is imposed on.
Just as price elasticities of supply and demand determine the distribution of the
tax burden, they also determine the inefficiency of taxation.
Higher elasticities imply bigger changes in quantities, and larger deadweight loss.

4
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

Demand inelastic & Dead Weight Loss


(DWL) is small
Figure 34.2 a

Demand elastic & DWL is larger.


Figure 34.2 b

Consider a tax on producers

10.5 ELASTICITIES DETERMINE TAX INEFFICIENCY


The inefficiency of any tax is determined by the extent to which consumers and
producers change their behavior to avoid the tax.
individuals and firms making inefficient consumption and production
choices in order to avoid taxation
Inelastic demand : large change in market prices with consumers bearing
most of the tax
Little change in quantity, lower DWL
Elastic demand: market prices change less and producers bear more of the tax.
Greater reduction in quantity, greater DWL.

10.6 EFFICIENCY COST: PROPERTY 2


Deadweight loss also rises with the square of the tax rate.
Larger taxes have much more Deadweight Loss than smaller ones.
As the tax rate doubles the deadweight loss triangle quadruples.

5
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

As the market moves farther and farther from the competitive equilibrium, there is
a widening gap between demand and supply. The loss of these higher surplus
trades means marginal Deadweight Loss gets larger.
Marginal deadweight loss is the increase in deadweight loss per unit
increase in the tax.

Figure 34.3 a
Harberger trapezoid
Government revenue loss: Rectangle in trapezoid This area is proportional to the
change in tax rate, .
Consumer surplus & Producer surplus: triangles in trapezoid Proportional to the
square of change in tax rate,
.

Harberger Trapezoid
Figure 34.3 b
Where

CS = Consumer Surplus
PS = Producer Surplus
6

Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

As tax rate doubles the DWL triangle quadruples. So the Marginal DWL
increases to a value four times the initial DWL, when tax rate is doubled.
Total DWL from 2t tax is ADE in fig 34.3b.
The area BC DE is 3 times larger than ABC.

7
Indian Institute Of Technology, Kanpur

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