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Taxes, Economics Of

The vision of sound taxes as the foundation of a wellregulated republic goes back at least to the revolutionary Dutch state of the 1790s. Policy makers over the years have sought to balance general goals of good taxation—efficiency, fairness, and low administrative (or transaction) costs—against the desire to use taxes to promote various social goals, including redistributing wealth, subsidizing particular industries, and rewarding or punishing particular behaviors. Economists have been in the forefront of the positive analysis of and normative debates about taxes, perhaps because the subject so readily lends itself to quantification and quantitative analysis. A rich public finance literature exists, so extensive as to defy comprehensive summarization. Instead, the focus here will be several important issues involving the economics of taxes.

Optimal Taxation

The core question in the economics of taxation is the extent to which particular taxes are inefficient. A tax that minimizes distortions in behavior among taxpayers is optimal. Frank Ramsey provided the canonical analysis. A tax for which all taxpayers are equally responsible is considered the best (assuming there is no difficulty in determining what constitutes a taxpayer), but that is not feasible. The second-best solution, Ramsey proved, is commodity taxation, where the rate of tax on each commodity is inversely proportional to the elasticity of the commodity's demand. Given the difficulty of projecting this elasticity much beyond the pretax price point, the insight, although profound, is of debatable practical value.

A further consideration in tax design is optimal progressivity. For any given redistribution goal, an income tax can be designed that will have the least effect on efficiency. General conclusions are difficult to draw, although for a wide range of assumptions, scholars indicate that the top income-tax bracket should be closer to 30 percent than to 50 percent.

Joel Slemrod argues that a flaw in the optimal tax literature is its exclusive focus on tax base and rate structure and a consequent tendency to assume away problems of implementation. People resist paying taxes, causing the government to invest in coercive measures. He argues that given the difficulty of determining the optimal tax structure, public policy should concentrate on minimizing the cost of collecting taxes for any given revenue goal. These costs include the incidence of tax evasion, as well as investments made to reduce that incidence. Slemrod foresees a day when the debate would involve optimal tax administration rather than the optimal tax base and rates.

Taxes as Instruments of Redistribution

Economists do not argue over whether taxes should serve redistributive ends so much as whether they should be the exclusive means of doing so. Welfare economics admits a wide range of social objectives, including the redistribution of financial attributes (wealth or income) that provide a basis for equalizing life opportunities. Economists for the most part do not address the question of how much redistribution a society should seek but instead look at the question of how to minimize the social costs of redistribution.

Taxes induce inefficiency to the extent that they apply to goods for which untaxed substitutes exist. In the case of income taxation, analysts note that to some extent, work and leisure are substitutes. Income taxes used to redistribute income reduce aggregate economic product to the extent that taxpayers respond to the tax by working less than they would were there no tax. Whether work and leisure are substitutes, and whether the substitution effect varies with income levels, are themselves controversial.

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