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Theory of Optimal Taxation: Making Good Cents

Background

Governments need money to operate. It takes money to fix infrastructure, fund welfare programs, and run various projects. Hence the dreaded compulsory contribution to the federal piggy bank - taxes. A fee is placed on certain goods, activities, and transactions to raise revenue. Consumers still get their products and services, companies still turn their profits, and the government has some funds to redistribute as it sees fit. Everyone gets what they want, right?

Here’s the Catch

Creating the right tax is a huge balancing act. Adding an additional charge that consumers, producers, or both have to pay will always influence the market. The goal is to make that influence negligible so the market stays relatively stable while revenue is raised. Otherwise the tax might inadvertently create a market failure, thus ensuring the new tax doesn’t collect a cent.

Theory of Optimal Taxation

The theory of optimal taxation is all about finding the delicate balance between securing government funds and maximizing the preferred market behavior. Frank Ramsey is credited for developing the economic theory behind optimal taxation, but optimal tax theory has greatly evolved since him due to numerous contributors.  Broadly speaking, the theory of optimal taxation is the study of creating and implementing taxes that ensure the highest social welfare function while raising maximum revenue. Social welfare function is a way of ranking various social states as undesirable, indifferent, or desirable. In terms of optimal taxation, maximizing a social welfare function is ensuring desirable social states, such as continued preference for the item being taxed.

How It Works

The key to creating optimal taxation is to be aware of elasticity. Elasticity is the measure of how much particular economic variables change as a response to change in different economic variables. 

Taxes will affect market response to the things being taxed, so the elasticity of supply and demand of those goods in response to the added tax is very important. If something is elastic, that means it’s subject to a great amount of change. If the demand for rubber ducks is elastic, it’s not a good item to place a tax on: if Mary has to increase the selling price for rubber ducks, the demand for the toy is liable to drop.  Conversely, if something is inelastic, there isn’t going to be much change. If Dave owns an apple farm, he’s not going to be able to cut down on the amount of apples grown during harvest season without throwing away money. Thus he’s going to offer the same amount of apples for sale regardless of whether five or fifty people want to buy his apples. His supply of apples is inelastic, or at least less elastic than the demand for Mary’s ducks.

It’s more profitable then to tax relatively inelastic goods and services. This helps verify that the predicted revenue generated from the tax will actually get collected. If elastic goods and services are taxed, people will just stop buying them, destroying the market and ensuring Uncle Sam doesn’t get his dues. 

To further optimize the tax, it should be broad based. In other words, a tax shouldn’t be placed on glass slippers - very few people are going to purchase them. Instead a tax could be placed on glass production - there’s a large demand for glass in various forms, from dishware to windows to art. 

Finally an optimal tax needs to be a low rate one. Gas prices nowadays are considered to be fairly inelastic in their demand. Cars will still need the same amount of fuel to run regardless of whether the tax is five cents or six cents per gallon. People use cars as their main form of transportation to get to school, work, and home, so while they might grumble about the penny increase, they’ll still purchase basically the same amount of gas. However, if the tax then jumped to five dollars, there’d be mass outcries. Best case scenario, people would just stop buying the product. Worst case scenario, it could jumpstart revolt - history is littered with examples of heavy taxes inciting rebellion, from the Boston Tea Party to the Indian Salt March. Keeping a low tax rate ensures maximum payment and peace.

Why Care?

Taxes are a necessary evil of keeping a government operational, but that doesn’t mean taxes have to be full-scale weapons of evil. If they’re kept at a low rate, applied to a broad base on inelastic goods and services, they can be effective and innocuous. More recently, economists have stressed that taxes should also be equitable, which means they should be fair. Optimal taxation should create a financial burden in proportion to how much a person can pay. They shouldn’t unfairly burden those of lower income brackets. 

Economists agree on these conditions for creating optimal taxes but disagree on how to practically implement them. Lump sum taxes, which have fixed rates regardless of income and are applied to everyone, are considered to be minimally distorting to the market. Similarly, Pigouvian taxes place a price tag on inefficient goods and thus help bring a market closer to an efficient level. As such, they’re two forms of taxes that are being heavily studied by optimal taxation theorists. 

Optimal tax theory is vital to keeping a government running. Taxes should be fair and reasonable. When they’re not, those who can afford to not pay them will refuse to do so. After all, if a government is being unjust, why fund further injustices?

Think Further

  1. Can you think of any other types of taxes that follow optimal tax theory?
  2. Which of the listed factors do you think is most important when it comes to implementation of optimal tax theory? Why?
  3. Think of a tax that you, a friend, or guardian regularly pays. Do you think it follows optimal tax theory? Why or why not?

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  1. Baumol, J William and David F. Bradford. “Optimal Departures from marginal Cost Pricing.” The American Economic Review, vol 60, no 3,  Jun 1970, pp 265-283.
  2. Feldstein, Martin. “Effects of Taxes on Economic Behavior.” National Tax Journal, vol 61, no 1, Mar 2008, pp 131-139. Doi: 10.3386/w13745.
  3. Mankiw, Gregory, Matthew Weinzierl, and Danny Yagan. “Optimal Taxation in Theory and Practice.” Journal of Economic Perspectives, vol 23, no 4, Fall 2009, pp 147-174.
  4. Ramsey, F. P. “A Contribution to the Theory of Taxation.” The Economic Journal, vol 37, no 145, Mar 1927, pp 47-61. Doi: 10.2307/2222721.
  5. Slemrod, Joel. “Optimal Taxation and Optimal Tax System.” Journal of Economic Perspectives,  vol 4, no 1, Winter 1990, pp 157-178. Doi: 10.3386/w3038.