The Role of Commodity Taxation in Pareto Ecient Tax Structures for Redistribution

John Burbidge 13 February 2012

Introduction

Redistribution within and across cohorts is a major part of what many governments do and is the subject of a large literature in public economics. Most of this literature assumes that agents have the same utility function and the ability to choose between leisure and time at work; agents dier only in their abilities to earn income, and these ability dierences are reected in wage rates. If a government could observe ability and had access to a lump-sum tax it could achieve any desired rst-best outcome. The literature purports to focus on governments without either power. Such governments operate in a world where observable variables like earnings or consumption are the only things that can be taxed. In this setting key questions are the ecient mix of direct (earnings, interest income) versus indirect (commodity) taxation, and the particular question of optimal commodity tax rates. Most of this paper is about the latter. I look rst at the literature that ows from Mirrlees (1971) and Atkinson and Stiglitz (1976) on Pareto ecient tax structures with nonlinear earnings taxation. A well known result is that in the presence of an optimal nonlinear earnings tax, uniform commodity taxation is ecient if leisure and goods are weakly separable. I argue that nonlinear earnings taxes are equivalent to the power to levy lump-sum taxes conditional on earnings and show that this
Department of Economics, University of Waterloo, Waterloo, Ontario, Canada, N2L 3G1, jburbidg@uwaterloo.ca.

commodity tax result has content only when the constraint that high-ability people not mimic low-ability people binds. I then focus on Pareto ecient tax structures for redistribution with proportional commodity tax rates. Deaton (1979) argued that the distance function was helpful in solving the Ramsey (1927) tax problem and that uniform commodity taxation was ecient if and only if leisure and goods were implicitly separable. Besley and Jewitt (1995) showed that Diamond and Mirrlees (1971) were overly cautious in estimating the diculty of identifying necessary and sucient conditions for the optimality of uniform commodity taxation. Besley and Jewitt used an expenditure function approach to show that implicit separability of leisure and commodities is sucient but not necessary uniform commodity taxation is ecient if and only if the ratios of Hicksian demands for commodities are independent of the wage rate. This paper builds on Deatons analysis to derive the distance function analogue of Besley and Jewitts condition. The heart of the Ramsey tax problem is that leisure cannot be taxed directly and therefore commodities that are more complementary with leisure, with utility held constant, should be taxed at higher rates; if all commodities are equally complementary with leisure uniform commodity taxation is ecient. Moving from the Ramsey problem to the problem of redistributing from a high-ability person to a low-ability person creates a force in the opposite direction. Assuming the two types have the same utility function, in a neighbourhood of the private equilibrium, it will be ecient to tax the good that is more complementary with leisure at a higher rate, and this will still be true when redistribution reaches the point where the mimicking constraint starts to bind. At this point some taxation of the earnings, that is the work, of the low-ability person becomes ecient because it discourages the high-ability person from mimicking the low-ability person. As further redistribution is undertaken the force of taxing work grows relative to that of taxing leisure and uniform taxation of commodities becomes a possibility, as is the possibility of taxing more heavily the commodity that is a substitute for leisure. Towards the end of the paper I correct and extend Alvarez et al.s (1992) analysis of the Ramsey problem with a life-cycle consumer. I identify necessary and sucient conditions for uniform earnings taxation and uniform commodity taxation, with and without age-conditioned earnings tax rates. And I show what these conditions are in the particular case an additively separable lifetime utility function with a constant utility discount rate.

Commodity taxation with a nonlinear earnings tax

Consider an economy with two types of price-taking agents who dier only in their wage rates. Let each have T units of time to allocate to leisure, l, or to work. Assume earnings have to be spent on goods 1 and 2. In obvious notation each types budget constraint can be written as wj lj + p1 xj + p2 xj = wj T, 1 2 j = A, B, wA > wB .

Assume the government wishes to redistribute money from the As to the Bs. With an unrestricted nonlinear earnings tax the government can choose a marginal tax rate for each type and a number for the total tax paid by each A and, assuming no revenue is lost in redistribution, these numbers will determine the ow of money to each B and the price of leisure to A and B. The private equilibrium in this model is Pareto ecient. As the government picks its tax instruments to maximize the utility of each A given a utility level for each B that is higher than that at the private equilibrium, initially the government will choose zero marginal tax rates for each type and a positive total tax number for each A. In other words, in a neighbourhood of the private equilibrium an optimal nonlinear earnings tax structure is equivalent to a lump-sum tax structure. On this section of the utility possibility frontier (upf) adding commodity tax rates would be pointless whatever the form of the utility function and the relationship between leisure and goods because the nonlinear earnings tax system can achieve a rst-best outcome. Assuming the government can observe only earnings and not wage rates the tax parameters must depend only on earnings, and as the B level of utility is increased, there will come a point where the As will want to mimic the Bs. Denote mimicking levels of variables by an m subscript. When an A A is mimicking a B, lm satises
A wA T lm = wB T lB ,

A u lm , xA , xA = u lA , xA , xA , 1m 2m 1 2 A and xA , xA maximize utility given lm and the constraint that the expen1m 2m diture of a mimicking A equals the expenditure of each B. As the mimicking constraint starts to bind the government moves onto a second-best upf inside

the rst-best upf. Assume for the moment that commodity tax rates are set to zero. Distorting the As labour-leisure choice with a marginal tax (or subsidy) rate on their earnings would be inecient. But levying a marginal tax rate on the earnings of the Bs discourages the As from mimicking the Bs because mimicking As would have to pay this tax which helps the government cope with the mimicking constraint. What about commodity taxation when the mimicking constraint is binding? If leisure and goods are weakly separable each As commodity-consumption plan when mimicking will be the same as each Bs plan (As utility level will be higher because of higher leisure). Here, commodity taxation simply distorts the consumption plan of both types and oers no leverage in dealing with the mimicking constraint. So, for example, if u (l, x1 , x2 ) = x1 x2 + x1 + l1/2 , then commodity taxation is unhelpful. But if u (l, x1 , x2 ) = x1 x2 + x1 l1/2 , then a commodity tax on good 1 encourages the Bs to consume more leisure and to work less; this complements the positive marginal earnings tax rate on the Bs. To summarize, a Pareto ecient tax structure with an unconstrained nonlinear earnings tax in this setting entails lump-sum taxation of the As, positive marginal tax rates on the Bs when the mimicking constraint binds and commodity taxation when the mimicking constraint binds and leisure and goods are not weakly separable. I now examine Pareto ecient tax structures when lump-sum taxation is not an option.
1/2 1/2 1/2 1/2 1/2 1/2

Ramsey with two goods and leisure

As above, with two goods and leisure, each persons budget constraint can be written as wl + p1 x1 + p2 x2 = wT. Assume that the government wishes to raise given revenue from these people with the smallest decrease in their utility and lump-sum taxes are ruled out. If the government were able to tax leisure directly a proportional 4

tax rate on goods and leisure at rate t would function as a lump-sum tax on the time endowment because the following budget constraints (1 + t)(wl + p1 x1 + p2 x2 ) = wT wl + p1 x1 + p2 x2 = w(1 t )T are the same if 1 = 1 t . 1+t Assuming that leisure cannot be taxed directly and that the government uses proportional tax rates, the options in the present setting are commodity taxes, t1 and t2 and an earnings tax, te . Since the following equations (1 + t1a )p1 x1 + (1 + t2a )p2 x2 = (1 te )w(T l) (1 + t1 )p1 x1 + (1 + t2 )p2 x2 = w(T l) are the same if tj are dened by 1 + tja , 1 te assuming the government uses only commodity tax rates does not diminish the governments eectiveness. Second-best optimal commodity tax rates must address the only issue standing in the way of a rst-best outcome leisure cannot be taxed directly. Thus the answer to the question of whether good 1 or good 2 should be taxed at a higher rate must be that whichever of goods 1 or 2 is more complementary with leisure should be taxed at a higher rate. Since the deadweight loss of any tax works solely o substitution eects and these are dened with utility held constant I need a construct that isolates the relationship between good 1 and leisure and good 2 and leisure, with utility held constant. This construct is the distance function. If u(l, x1 , x2 ) is the ordinary utility function d(l, x1 , x2 , u0 ) is dened by 1 + tj u l x1 x2 , , d(l, x1 , x2 , u0 ) d(l, x1 , x2 , u0 ) d(l, x1 , x2 , u0 ) 5 = u0 , (1)

that is, d(l, x1 , x2 , u0 ) is the number by which an arbitrary consumption vector must be scaled to deliver utility level u0 , and u(l, x1 , x2 ) u0 if and only if 1 d(l, x1 , x2 , u0 ). (2)

For the moment, set all tax rates to zero to reduce clutter. The next few paragraphs follow Deaton (1979) in showing the duality between the distance function and the expenditure function, e (w, p1 , p2 , u0 ). The scaled vector l x1 x2 , , , d(l, x1 , x2 , u0 ) d(l, x1 , x2 , u0 ) d(l, x1 , x2 , u0 ) will deliver a utility level of u0 and so the expenditure function must satisfy e (w, p1 , p2 , u0 ) wl + p1 x1 + p2 x2 . d(l, x1 , x2 , u0 )

But if (l , x , x ) are chosen to be the Hicksian demand levels for these prices 1 2 and utility level u0 then d (l , x , x , u0 ) = 1 and 1 2 e (w, p1 , p2 , u0 ) = Thus e (w, p1 , p2 , u0 ) = Min wl + p1 x1 + p2 x2 . l, x1 , x2 d(l, x1 , x2 , u0 ) (3) wl + p1 x + p2 x 2 1 . d(l, x1 , x2 , u0 )

Similarly, for an arbitrary price vector, (w, p1 , p2 ) d (l, x1 , x2 , u0 ) wl + p1 x1 + p2 x2 e (w, p1 , p2 , u0 )

Now let prices be (w , p , p ) which (not uniquely) generate a budget plane 1 2 tangent to the u0 indierence surface at the point where the ray from the origin to (l, x1 , x2 ) cuts this indierence surface. Then d (l, x1 , x2 , u0 ) = so d (l, x1 , x2 , u0 ) = Min wl + p1 x1 + p2 x2 . w, p1 , p2 e (w, p1 , p2 , u0 ) 6 (4) w l + p x1 + p x2 1 2 e (w , p , p , u0 ) 1 2

Equations (3) and (4) clearly show the duality between the distance function and the expenditure function. Just as the Hessian of the expenditure function must be symmetric and negative semi-denite, so must the Hessian of the distance function (the Antonelli matrix) be symmetric and negative semi-denite (again, see Deaton (1979)). Reintroduce commodity tax rates. Since earnings are the only source of revenue for the household, earnings are not taxed and initial prices (w, p1 , p2 ) are assumed to be constant, e (w, (1 + t1 )p1 , (1 + t2 )p2 , u0 ) = wT. Applying the envelope theorem to (4) with commodity tax rates in place, obtain d (l, x1 , x2 , u0 ) l w 1 = = e (w, (1 + t1 )p1 , (1 + t2 )p2 , u0 ) T d (l, x1 , x2 , u0 ) (1 + t1 )p1 a2 (l, x1 , x2 , u0 ) = x1 wT d (l, x1 , x2 , u0 ) (1 + t2 )p2 a3 (l, x1 , x2 , u0 ) = x2 wT a1 (l, x1 , x2 , u0 )

(5) (6) (7)

The most intuitive results can be derived by assuming that the government chooses x1 and x2 , with l adjusting to maintain a1 (l, x1 , x2 , u0 ) = 1/T , to maximize revenue given a utility level no lower than u0 . Using (2) the governments problem can be written as: Max wT wl p1 x1 p2 x2 + (1 d (l, x1 , x2 , u0 )) x1 , x2 , Taking the derivative with respect to x1 obtain

 dl d dl d = w p1 + x1 dx1 l dx1 x1 dl d dl d = w + (1 + t1 ) p1 + (1 + t1 ) p1 p1 + dx1 l dx1 x1 d dl d dl + a2 + t1 p1 + [use (5) and (6)] = wT a1 dx1 l dx1 x1 dl = t1 p1 ( + wT ) a1 + a2 dx1 Setting /x1 = 0 dl + a2 dx1 a1 dl t1 p1 = ( + wT ) 1 + a2 a2 dx1 a1 dl t1 = ( + wT ) 1 + wT (1 + t1 ) a2 dx1 + wT t1 a1 dl = 1+ (1 + t1 ) wT a2 dx1 t1 p1 = ( + wT ) a1 Dierentiating a1 = 1/T with respect to x1 dl a12 = dx1 a11 Thus t1 + wT = (1 + t1 ) wT a1 a12 a11 a2

(8)

Given a similar formula for the tax rate on good 2 and the symmetry of the Antonelli matrix t2 + wT t1 = 1 + t1 1 + t2 wT 8 1 a 11

(a a ) 21 31

(9)

where a ij aij . ai

(10)

The rst term is positive because the desired utility level must be at least u0 , that is, 1 d (l, x1 , x2 , u0 ) 0 and so > 0. The second term is positive because the Antonelli matrix is negative semi-denite and thus t1 t2 = Sign a a . 31 21 1 + t1 1 + t2 a measures the degree of complementarity between good j 1 and leisure j1 holding utility constant. If good 1 is more complementary with leisure than is good 2 then it is ecient to tax good 1 at a higher rate than good 2 because doing so helps compensate for the inability to tax leisure directly. Since Sign ln (a2 /a3 ) = a a 21 31 l and a2 and a3 are positive I can write (a2 /a3 ) 0. (11) l In particular, a necessary and sucient condition for the eciency of equal proportional taxation of commodities 1 and 2 is that a2 /a3 be independent of leisure. The result in (11) is the same as equation (52) in Deaton (1979) and, given the duality between the expenditure function and the distance function described by Deaton (1979), (5.1) in Besley and Jewitt (1995). t1 t2 if and only if (h1 /h2 ) 0, (12) w where hj = e (w, p1 , p2 , u0 ) /pj is the Hicksian demand for commodity j. The slip in Deaton (1979), which Besley and Jewitt correct, is in jumping from (11) to saying that (11) holds if and only if leisure and goods are implicitly separable, that is, d (l, x1 , x2 , u0 ) can be written as d (l, u0 , f (x1 , x2 , u0 )). In a note on the literature that followed Atkinson and Stiglitz (1976), Auerbach (1979) showed that with the additively separable utility function mentioned in the previous section, that is, t1 t2 if and only if 9

u (l, x1 , x2 ) = x1 x2 + x1 + l1/2 , uniform commodity taxation is never ecient in the Ramsey setting the optimal level of t1 will always exceed the optimal level of t2 . I now examine Pareto ecient tax structures with just commodity taxation and then I consider linear progressive taxes.

1/2 1/2

1/2

Commodity taxation with a linear progressive earnings tax

Reconsider the setting of section 2 where A and B have the same preferences and dier only in their wage rates and assume the government can use only proportional commodity taxation to redistribute money from the As to the Bs. Near the private equilibrium, it will be optimal to tax whichever of commodities 1 or 2 is more complementary with leisure, holding utility constant, as specied in equation (11). So, for example, with the utility function in Auerbach (1979), the government will tax commodity 1 at a higher rate than 2. Starting from the private equilibrium there will come a point along the upf in the direction of higher B utility where As utility will equal the utility an A would have if he mimicked a B. At the point where the mimicking constraint starts to bind t1 > t2 because leisure cannot be taxed directly and good 1 is more complementary with leisure than is good 2. But dealing with the mimicking constraint creates a force in the opposite direction. To discourage the As from mimicking the Bs its optimal to tax the earnings of the Bs which implies a lower tax rate on leisure and a reduction in the gap between t1 and t2 . In this example, as the utility of a B is increased with a binding mimicking constraint, t2 will at some point equal t1 and then exceed t1 . This shows that when redistribution is being undertaken t1 = t2 may be ecient even when a > a . 21 31 As explained above, adding a proportional earnings tax rate to the governments instruments would not change the attainable upf. Would a piecewise linear progressive earnings tax help? The answer is no because eciency requires a zero marginal tax rate on the earnings of the As and a positive marginal earnings tax rate on the Bs and this is ruled out by assumption with a progressive linear earnings tax.

10

Commodity taxation in a life-cycle model

Consider the Ramsey problem in a two-period environment.1 With a complete set of age-conditioned proportional consumption and earnings tax rates, and an interest tax rate, the lifetime budget constraint could be written as (1 + tc ) c2 2 1 + (1 tr ) r (1 te ) w2 (T l2 ) 2 . = (1 te ) w1 (T l1 ) + 1 1 + (1 tr ) r (1 + tc ) c1 + 1 Setting tr = 0 for the moment d (l1 , l2 , c1 , c2 , u0 ) l1 (1 te ) w1 1 W (1 te ) w2 /(1 + r) 2 W (1 + tc ) 1 W (1 + tc ) /(1 + r) 2 , W

(13)

a1 (l1 , l2 , c1 , c2 , u0 ) = a2 (l1 , l2 , c1 , c2 , u0 ) = a3 (l1 , l2 , c1 , c2 , u0 ) = a4 (l1 , l2 , c1 , c2 , u0 ) = where

(14) (15) (16) (17)

W (1 te ) w1 T + 1
1

(1 te ) w2 T 2 . 1+r

(18)

I use numerical simulations to teach. In a grad class at McMaster in the late 1980s I used a numerical simulation of a partial-equilibrium life-cycle model to show the students something everyone knew an interest tax is inecient relative to earnings or consumption taxes. We discovered cases where an interest tax is ecient. Trying to understand the role of interest taxation in life-cycle models led eventually to Deaton (1979) and Alvarez, Burbidge, Farrell and Palmer (1992) was based on Deatons article. Subsequently Besley and Jewitt (1995) showed that Deaton did not get the necessary and sucient conditions for the eciency of uniform commodity taxation quite right and I realized that Alvarez et al. should be amended. This is one of the objectives of this section. The results in this section are written so that it should be clear how to extend them to more than two periods.

11

The optimal commodity tax structure depends on the governments ability to age condition earnings tax rates, that is, whether or not the government can set te at a dierent rate from te . I begin with the case where the govern1 2 ment does have this power and then deal with the situation where it cannot age condition earnings tax rates. Note that the budget constraint implies that if the government cannot age condition earnings tax rates then in eect commodity tax rates are its only instruments.

5.1

Commodity taxation with age-conditioned earnings tax rates

In the one-period model much simplication followed from the equation a1 (l, x1 , x2 , u0 ) = 1/T (equation (5)). Looking at (14), (15) and (18) the equivalent restriction in the current context is a1 (l1 , l2 , c1 , c2 , u0 ) + a2 (l1 , l2 , c1 , c2 , u0 ) = 1/T. (19)

With te set at zero, think of the government choosing (l2 , c1 , c2 ) with l1 1 endogenous to maintain (19), to maximize the Lagrangian w2 l2 c2 w2 T w1 l1 c1 + (1 d (l1 , l2 , c1 , c2 , u0 )) . 1+r 1+r 1+r

w1 T + Then

w2 d dl1 d dl1 = w1 + l2 dl2 1 + r l1 dl2 l2 dl1 w2 dl1 = W a1 + a2 + a2 W a1 + a2 dl2 1+r dl2 dl1 te w2 = ( + W ) a1 + a2 2 dl2 1+r Setting /l2 equal to zero and dividing by a2 W obtain te +W 2 = e 1 t2 W 12 a1 dl1 a2 dl2

1+

Using (19), dl1 a12 + a22 = , dl2 a11 + a21 and remembering that the Antonelli matrix is symmetric and that a ij aij /ai (10), the te equation can be rewritten as 2 te +W 2 = 1 te W 2 1 a + a 12 11 (a + a a a ) . 11 12 21 22

(20)

The rst two terms are positive so the sign of te is the sign of the last term. 2 Most applied work assumes the lifetime utility function has the form 1 f (l2 , c2 ) , 1+

u (l1 , l2 , c1 , c2 ) = f (l1 , c1 ) +

(21)

so the distance function d (l1 , l2 , c1 , c2 , u0 ) is implicitly dened by u0 = f l1 d1 , c1 d1 + f 1 l1 d1 , c1 d1 g 1 l1 d1 , c1 d1 1 f l2 d1 , c2 d1 1+ 1 f 2 l2 d1 , c2 d1 + 1+ + g 2 l2 d1 , c2 d1 .

Using implicit dierentiation one can show that

13

ai aij m n q s I (m, n) ij

m (d) gq and 1 m I (m, n) gqs ai ns aj mq + ai aj , where the period of i the period of j 1 if i is leisure, 2 if i is consumption 1 if j is leisure, 2 if j is consumption 1 if m = n, 0 otherwise 1 1 2 2 l1 g1 + c1 g2 + l2 g1 + c2 g2 i i d1 li g1j + ci g2j

2 1 1 1 2 2 2 2 d2 l1 g11 + 2l1 c1 g12 + c2 g22 + l2 g11 + 2l2 c2 g12 + c2 g22 . 1 2

The sign of te in (20) is 2 the sign of a + a a a = 11 12 21 22 1 2 2 1 1 2 the sign of (1 + ) c1 f2 + c2 f2 f1 f11 f1 f11 + 1 2 1 2 2 1 (1 + ) f1 + f1 c2 f1 f12 c1 f1 f12 + [l2 l1 ]
2 f1 2 1 1 f11 + (1 + ) f1 2 2 f11

(22)

If the real interest rate, r, equals the utility discount rate, , and w1 = w2 , then the optimal proles for leisure and consumption over the life cycle are 2 1 at and f = f so each of the square brackets is zero and the optimal value of te is zero. For values of r a little higher, the rst two square brackets 2 i are close to zero and the last term is negative because now l2 > l1 and f11 < 0 with f is strictly concave. Why is it optimal to have a negative second-period earnings tax rate in this setting? Remember that tax rates were normalized by setting the rst-period earnings tax rate equal to zero. When r > , l2 > l1 and the government would like to tax second-period leisure at a higher rate than rst-period leisure, but, of course, the government cant tax leisure directly. The second-best option is to tax second-period work or earnings at a lower rate than rst-period earnings. 14

Let me move on to commodity taxation. One can show that the equivalent of (9) in the present context is tc tc +W 1 2 = c c 1 + t1 1 + t2 W 1 + a 12

a 11

(a + a a a ) . (23) 41 32 31 42

The rst pair of terms in the last bracket measure the degree of complementarity between c1 and (l1 , l2 ) and the second pair measure the same thing for c2 . The intuition for this result could not be more straightforward: tax rst-period consumption at a higher rate than second-period consumption if rst-period consumption is more complementary with leisure. With additively separable utility the sign of tc tc is 1 2 the sign of a + a a a = 31 32 41 42 1 2 2 1 1 2 the sign of (1 + ) c1 f2 + c2 f2 f2 f12 f2 f12 + 1 2 1 2 2 1 (1 + ) f1 + f1 c2 f2 f22 c1 f2 f22 + 2 2 1 1 1 2 [l2 l1 ] f1 f2 f12 + (1 + ) f1 f2 f12 .

(24)

Again, if the real interest rate, r, equals the utility discount rate, , and w1 = w2 , then the optimal proles for leisure and consumption over the life 1 2 cycle are at and f = f so each of the square brackets is zero and equal commodity tax rates are ecient. For values of r a little higher, the rst two square brackets are close to zero and the last term is positive if i f12 > 0 because now l2 > l1 . When r > , l2 > l1 and the government would like to tax rst-period leisure at a lower rate than second-period leisure, and i with f12 > 0, taxing rst-period consumption at a higher rate is like taxing rst-period leisure at a lower rate.

5.2

Commodity taxation without age-conditioned earnings tax rates

As noted above, there is no loss in generality here in assuming the governments only instruments are age-conditioned consumption tax rates. With te = te = 0 equations (14), (15) and (18) imply the following two equations 1 2 determine (l1 , l2 ) as functions of (c1 , c2 ):

15

a1 (l1 , l2 , c1 , c2 , u0 ) =

w1 W w2 /(1 + r) a2 (l1 , l2 , c1 , c2 , u0 ) = , W

(25) (26)

and the right-hand side of each equation is a constant. The rst-order conditions imply tc tc +W 1 2 = c c 1 + t1 1 + t2 W a1 dl1 a2 dl2 a1 dl1 a2 dl2 + a3 dc1 a3 dc1 a4 dc2 a4 dc2 to (25) and (26) the right-hand side a12 a1 a11 a12 a1 1 a22 a2 det a21 a22 a2 a4 a32 0 a41 a42 0

Applying the implicit function theorem can be written as a11 1 +W 1 det a21 W a3 a11 a12 a31 det a21 a22 which can be rewritten as

+W W Thus

1 det a 11 a 21 a 12 a 22

a a 1 11 12 1 . a a det 22 21 a a a a 0 42 32 41 31

tc tc +W 1 2 = c c 1 + t1 1 + t2 W

1 det a a 11 12 a a 22 21

(a a ) (a a ) 41 12 22 31 (a a ) (a a ) 32 21 42 11 (27)

The sign of the left-hand side is the same as the sign of the last term. Compare the results here with those of the previous subsection. If it happens that uniform earnings taxation is ecient, equation (20) says that a a = a a > 0 12 22 21 11 16

so the sign of tc tc in equation (23) is the same as the sign in (27). 2 1 With additively separable utility the sign of tc tc is 1 2 the sign of (a a ) (a a ) (a a ) (a a ) = 31 41 12 22 32 42 11 21 1 2 1 2 1 2 1 2 2 1 the sign of (1 + ) c1 f2 + c2 f2 f2 f1 f11 f12 f1 f2 f12 f11 + 1 1 2 2 2 1 1 2 2 1 (1 + ) f1 f2 f12 + f1 f2 f12 c2 f1 f12 c1 f1 f12 +
1 (1 + ) f1 2 2 2 f11 + f1 2 1 f11 2 1 1 2 c1 f2 f22 c2 f2 f22 .

(28)

Again, if the real interest rate, r, equals the utility discount rate, , and w1 = w2 , then the optimal proles for leisure and consumption over the life 2 1 cycle are at and f = f so each of the square brackets is zero and equal commodity tax rates are ecient. But the class of utility functions yielding the eciency of uniform commodity taxation is broader in this subsection. For example, if f Cobb Douglas f (l, c) = l c , > 0, + < 1,

each of the square brackets in the last expression (28) is zero,2 whereas uniform commodity taxation is not ecient in general if age-conditioned earnings tax rates are available and f is Cobb Douglas.

5.3

An example

It is instructive to compare f logarithmic: f (l, c) = ln (l) + ln (c) , > 0, + < 1

with f Cobb-Douglas. Tax rates in tables 1 and 2 have been normalized with tc = 0. Inspection of the tables reveals that consumption-age and leisure2 age proles are much steeper with f12 positive as opposed to zero. With a full set of age-conditioned consumption and earnings tax rates (last column), steeper leisure-age proles imply stronger age-conditioning in earnings tax rates te te is larger. Note that each of the three terms in (24) is zero for 1 2 f logarithmic so in the last column of Table 2 tc = tc = 0. When I drop the 1 2 governments ability to age-condition consumption tax rates (next column
2

This is not true in general for f CES.

17

left in each table) utility drops for Cobb Douglas and nothing changes for logarithmic. Alvarez et al. (1992), Erosa and Gervais (2002) and Conesa et al. (2009) have observed that if age-conditioning of earnings tax rates is ruled out, an interest tax or subsidy may be a second-best option. In these tables, ecient earnings tax rates decline with age and this pattern is mimicked by a positive interest tax rate; note that utility rises from the rst to the second column in each table. In addition, note that the optimal level of tr is higher with log utility where no age-conditioning of consumption tax rates is optimal. With Cobb Douglas utility it is ecient to have tc > tc and an interest tax rate 1 2 takes this in the wrong direction; tr > 0 simulates tc > tc which moderates 1 2 the eciency of interest taxation with Cobb Douglas utility.

Summary

This paper makes the following points. First, the literature on redistribution with nonlinear earnings taxes assumes the government has the ability to levy lump-sum taxes and perhaps its most remarkable result is that lump-sum taxes arent enough when mimicking constraints bind a positive marginal tax rate on low-ability individuals is ecient and non-uniform commodity taxation may be ecient. Second, ruling out lump-sum taxes shifts the focus to the Ramsey problem. In the simplest two-person example, with two commodities, leisure and one utility function, the answer to the Ramsey problem must determine ecient tax policy in a neighbourhood of the private equilibrium. Third, for the Ramsey problem, using the distance function and thinking of the government choosing quantities to maximize revenue subject to a utility constraint exploits the similar structures of the objective function and the utility constraint so that the derivation of optimal tax formulae is easy and the formulae are easily interpreted. Fourth, all Ramsey results are based on the observation that leisure cannot be taxed directly therefore tax those commodities or earnings more highly if they are more complementary with leisure. Fifth, dealing with mimicking constraints creates a commoditytax force in the opposite direction taxing the work, or the commodity most complementary with the work, of lower ability people reduces the incentive to mimic. Putting Ramsey together with redistribution delivers examples where the forces balance and uniform commodity taxation is optimal. The tax literature has moved well beyond the simple settings studied in 18

this paper. The advantage of studying simple settings is that its transparent what is really going on and the importance is that the forces operating in the simple models are still present in the more complicated ones.

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References
[1] Alvarez, Y., J. Burbidge, T. Farrell and L. Palmer, 1992, Optimal taxation in a life-cycle model, Canadian Journal of Economics 25, 111122. [2] Atkinson, A. and J. Stiglitz, 1976, The design of tax structure: direct versus indirect taxation, Journal of Public Economics 6, 5575. [3] Auerbach, A.J., 1979, A brief note on a non-existent theorem about the optimality of uniform taxation, Economics Letters 3, 4952. [4] Besley, T. and I. Jewitt, 1995, Uniform taxation and consumer preferences, Journal of Public Economics 58, 7384. [5] Conesa, J.C., S. Kitao and D. Krueger, 2009, Taxing capital? Not a bad idea after all! American Economic Review 99, 2548. [6] Deaton, A.S., 1979, The distance function and consumer behaviour with applications to index numbers and optimal taxation, Review of Economic Studies 46, 391405. [7] Diamond, P.A. and J.A. Mirrlees, 1971, Optimal taxation and public production, American Economic Review 61, 827 and 261278. [8] Erosa, A. and M. Gervais 2002, Optimal taxation in life-cycle economies, Journal of Economic Theory 105, 338369. [9] Mirrlees, J.A., 1971, An exploration in the theory of optimum income taxation, Review of Economic Studies 38, 175208. [10] Ramsey, F.P., 1927, A contribution to the theory of taxation, Economic Journal 37, 4761.

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Table 1: Optimal taxes when within period utility is l c Tax instruments te 1 te 2 tc 1 tc 2 tr l1 l2 c1 c2 u te = te 2 1 0.243939 0.243939 0 0 0 0.605419 0.964678 0.183094 0.291742 0.937917 te = te , tr 2 1 0.238436 0.238436 0 0 0.032273 0.619488 0.928343 0.188712 0.282797 0.938080 te , te 1 2 0.244498 0.219934 0 0 0 0.624660 0.913933 0.188773 0.285171 0.938171 te , te , tc 1 2 1 0.219345 0.185076 0.056934 0 0 0.622153 0.917279 0.183810 0.299005 0.938258

Notes: T = w1 = w2 = = 1, r = 1.3, = 0.5, = 0.2, Rev = 0.1

Table 2: Optimal taxes when within period utility is ln (l) + ln (c) Tax instruments te 1 te 2 tc 1 tc 2 tr l1 l2 c1 c2 u te = te 2 1 0.243939 0.243939 0 0 0 0.683230 0.785714 0.206625 0.237619 -0.709831 te = te , tr 2 1 0.242176 0.242176 0 0 0.036811 0.687629 0.774320 0.208441 0.234719 -0.709752 te , te 1 2 0.248500 0.228023 0 0 0 0.688871 0.771189 0.207075 0.238136 -0.709733 te , te , tc 1 2 1 0.248500 0.228023 0.000000 0 0 0.688871 0.771189 0.207075 0.238136 -0.709733

Notes: T = w1 = w2 = = 1, r = 1.3, = 0.5, = 0.2, Rev = 0.1

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