Theory of Optimal Taxation: Excess Burden & Distortions of Taxation

Introduction

An appropriate tax system and its design in public finance are of major concern. Many attempts have been made to get the “Optimal Tax” policy but have been a complete failure in the practical tax design because they often ignore the range of considerations reflecting fiscal and societal institutions, which are essential both in normative as well as positive analysis of taxation.

In general, the standard optimal taxation procedure usually ignores the equity and efficiency relationship as taxes are always collected at a cost both to the government and the taxpayers. And similarly, this collection is enforced again at a cost to both parties.

Theory of Optimal Taxation

Optimal tax theory is the detailed study of the design and its implantation of such a tax structure, which can reduce inefficiencies and distortions in the market under the existing given economic market conditions.

This standard approach of optimal taxation is primarily based on some methodological assumptions. Example: A specific amount must be raised by the government in the form of revenues. This revenue is in turn dependent on the type of tax instruments available with the government, namely only commodity taxes, only income taxes or both of them are used.

The objectives of the government must be in coordination with the individual as well as the firm’s optimization. It should be for the social welfare.

A neutral tax is one which avoids distortions and inefficiencies, completely against the general notion of economists arguing that taxes generally distort behaviour.

A lot of the economic system depends on the type of tax system prevalent:

Optimal Commodity Taxes:

The objective of commodity tax rates on efficiency grounds is to achieve equal proportional reductions in the demands for all commodities, which gives lower tax rates for more elastic demands of the goods. While on equity grounds, the goods which have higher consumption by the lower income groups must be taxed low. Ramsey was the first to give his contribution to the said theory of optimal taxation, followed by many new ones by others. This problem is, therefore, also termed the “Ramsey Problem”.

His prime objective under his approach is to adjust consumption tax rates under specified constraints so that the least utility can be reduced. He proposed a solution to reduce the excess burden of consumption taxes, stating, “consumption tax on each good should be proportional to the sum of the reciprocals of its supply and demand elasticities.

Later, many new economists gave an alternative to Ramsey’s proposition by propounding tax systems, which take many tax structures simultaneously to define their theories.

Optimal Income Taxes:

When we talk of equity, it is said income tax should be more for those who earn more and lower for those who earn less. Even in certain cases income tax is levied to equalize after-tax incomes, therefore implying marginal tax rates to be 100%.

On another ground that of efficiency, a lower marginal tax rate brings more responsiveness in individuals in their labour decisions; that is to say, the smaller the spread in the skills of the individuals, the less concerned they are with equality in society and lower would be the amount of revenue that government must collect. We can even say that the marginal tax rate on the single richest individual should be zero.

Optimal Tax Mix:

When we talk on efficiency grounds, a lump sum income tax is required for an optimal tax mix, while commodity taxes are not used. On the other hand, on equity grounds, both the commodity as well as income taxes are used, though in certain circumstances, the optimal form of commodity tax rates is made uniform under optimal income tax so that the taxation of commodities at different rates is not optimal and only optimal income tax is used. Commodities that have more inelastic demands should be taxed highly to bring a reduction in the excess burden of taxation, but if these goods are majorly consumed by lower-income groups, then equity grounds of taxation demand lower tax rates.

Role of Equity in Optimal Tax Structure:

While discussing the optimal tax structure, the role of equity is important. Equity can be classified in the following two criteria:

1. Horizontal Equity: The horizontal equity principle says that the people earning the same, irrespective of their position or status, must pay the same. For example, Mr. B, a junior executive of X company, is paying a tax of 5000 (i.e. 10% on his salary of say 50000) then the clerk of some other company who is also earning the same 50000 bugs must pay 5000 lower in the company.

2. Vertical Equity: Vertical equity says that the payment of taxes should be dependent on the level of income earned, that is, the ability to pay. In other words, different people with different ability to pay must pay differently. For example, Mr Anudeep earns 50,000 bucks and pays 5,000 @ 10% on his salary as tax, and then Mr Bhanudeep, who is earning 5,000 bucks, must pay 500 bucks as tax @ same 10% on his salary.

Excess Burden of Taxation:

Excess burden, distortion cost, and deadweight loss of taxation are all synonymous terms used in economics. Excess burden is the most used in terminology amongst them, propounded by Adam Smith. It refers to the economic losses suffered by society due to the prevalent tax rates and subsidies by the government.

Economic theories state that distortions in taxes change economic behaviour and its consequences on the free market and its functioning. They make the behaviour different from the one which would be without taxes. There are two methods to calculate the excess burden.

1. Average Cost of Funds Approach: The average cost of funds is the division of the total cost of distortions by the total revenue collected by the government.
2. Marginal Cost of Funds Approach: The marginal cost of funds is the difference in the distortion by a unit increase in revenue of the government. In other words, it is the size of the distortion that is caused by the last additional unit of revenue of the government.

A similar distortion can be caused by subsidies also. Subsidies are generally taxes with negative rates.

Distortions of Taxation:

Any tax measure in all cases does distort and distract the economic behaviour than that which would have been in its absence. Similarly, progressive taxes also distort economic behaviour. However, the discretionary effects of a particular type of tax may be substituted by other benefits too, say, for example, the redistribution of tax amount collected from the higher income groups to the lower income groups who could possibly get more benefit from them.

Types of Distortions in Taxation:

Distortion can be of two types:

1. General Distortion
2. Deliberate Distortion

1. General Distortion:

Every type of tax does affect economic behaviour in general. For example, Sales tax on goods sold does have a direct effect on demand; that is, an increase in the tax rate will bring a decrease in the demand for that product by some percent and vice versa. Similarly, Income tax will tend to discourage people from earning more or towards the illegal practice of undeclared income. To overcome this tax, one may get involved in black money trading or even get distracted from work, hence leading to another economic problem of unemployment.

2. Deliberate Distortion:

Deliberate distortion is often created by the government with a positive approach to diminish the negative effects created by general distortion. So, not all distortions are bad. For example, Sin Taxes are levied on products that incur extra costs to society, like alcohol, tobacco pollution, etc. These types of taxes are also termed as Pigovian taxes.

Read More in: Theory of Public Finance

1. Public Finance: Meaning, Nature & Scope
2. Role of Government in Economy
3. Role of Government in Mixed Economy: Public & Private Sector
4. Role of Government under Cooperation and Competition
5. Role of Government in Economic Development and Planning
6. Concept of Public Goods, Private Goods, and Merit Goods
7. Concept of Market Failure and Functions of Government
8. Market Failure and Functions of Government: Decreasing Costs
9. Market Failure and Functions of Government: Externalities
10. Market Failure and Functions of Government: Public Goods
11. Future Market: Meaning, Role & Uncertainty
12. Concept of Information Asymmetry
13. Theory of Second Best: Concept & Explanation
14. Problem of Allocation of Resources: Public & Private Mechanisms
15. Preferences: Meaning, Types & Problems of Preference Revelation
16. Preference Aggregation & Its Mechanism
17. Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
18. Economic Theory of Democracy: Concept & Explanation
19. Politico Eco Bureaucracy: Concept & Explanation
20. Rent-Seeking and Directly Unproductive Profit-Seeking Activities
21. Rationale for Public Goods: Concept & Explanation
22. Benefit Theory or Voluntary Exchange Theory
23. Lindahl Model: Concept, Equilibrium & Limitations
24. Bowen Model: Concept, Advantages & Limitations
25. Samuelson’s Model of Public Expenditure
26. Musgrave’s Model of Public Expenditures
27. Demand Revealing Schemes for Public Goods
28. Vickery-Clarke-Groves Mechanism
29. Groves-Ledyard Mechanism
30. Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
31. Theory of Club Goods
32. Keynesian Principles of Stabilization Policy
33. Difference Between Keynesian Economic Thought and Others
34. Role of Expectations and Uncertainty in Formulating Stabilization Policy
35. Intertemporal Markets Efficiency & Failure
36. Liquidity Preference Theory
37. Diamond-Dybvig Banking Model
38. Preference Shocks, Adverse Selection & Central Bank
39. Equilibrium Deposit Contract
40. Social Goods and Its Effect on Stabilization Policy
41. Effect of Infrastructural Facilities on Stabilization Policy
42. Effect of Distributional Inequality on Stabilization Policy
43. Effect of Regional Imbalances on Stabilization Policy
44. Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
45. Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
46. Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
47. Pure Theory of Public Expenditure
48. Structure & Growth of Public Expenditure in India
49. Trends, Lessons & Priorities in Public Expenditure in India
50. Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
51. Performance Based Budgeting and Zero Based Budgeting
52. Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
53. Tax System and Its Principles
54. Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
55. Ability to Pay and Benefits Received Principle of Taxation
56. Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
57. Deadweight Loss of Taxation: Causes, Measurement & Example
58. Concept of Equity & Efficiency in Economics
59. Trade-Off Between Equity and Efficiency: Meaning & Example
60. Theory of Measurement of Dead Weight Loss
61. Double Taxation: Meaning, Desirability, Forms & Solution
62. Solution to Problem of Double Taxation: Intra-Country & International
63. Double Taxation Avoidance Agreement (DTAA) and Indian Policy
64. Classical View on Public Debt
65. Compensatory Aspect of Public Debt Policy
66. Public Debt or Borrowings: Concept, Need, Sources & Types
67. Concept of Public Debt or Public Borrowings
68. Need for Public Debt or Public Borrowing
69. Sources of Public Debt
70. Classification of Public Debt
71. Burden of Public Debt: Meaning, Types & Explanation
72. Debt Through Created Money or Deficit Financing
73. Public Debt (Public Borrowings) and Inflation (Price Level)
74. Crowding Out of Private Investment and Activity
75. Principle of Public Debt Management and Debt Repayment