Tax Inefficiencies and
Their Implications for
Optimal Taxation
20.1 Taxation and Economic
Efficiency
20.2 Optimal Commodity
Taxation
20.3 Optimal Income Taxes
20.4 Tax-Benefit Linkages
and the Financing of Social
Insurance Programs
20.5 Conclusion
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G.O.P. Blueprint Would Remake Health Policy
By ROBERT PEAR
Published: April 4, 2011
•
WASHINGTON — The proposal to be unveiled by House Republicans on Tuesday to rein in the long-term costs of
Medicaid and Medicare represents a fundamental rethinking of how the two programs work, an ambitious effort by
conservatives to address the nation’s fiscal challenges, and a huge political risk.
•
Under the proposal, Medicaid would be transformed into a block grant, with a lump sum of federal money given to
the states to care for low-income people. States would be given more discretion over use of the money than they
have under the current federal-state partnership.
•
For future Medicare beneficiaries — people now under 55 — Mr. Ryan’s proposal calls for the federal government
to contribute a specified amount of money toward the premium for private health coverage. Under the traditional
Medicare program, the government reimburses doctors and hospitals directly
•
Medicaid and Medicare are now open-ended entitlements. Anyone who meets the eligibility criteria is entitled to
benefits defined in detail by federal law. The federal government and the states must pay the additional cost if
more people become eligible for Medicaid, as happened in the recent recession
Likewise, Medicare bears the cost if doctors perform more numerous, more complex and expensive tests and
procedures. Some of those additional costs are passed on to beneficiaries in the form of higher premiums.
•
•
The Congressional Budget Office recently estimated that a Medicaid block grant, of the type proposed by Mr.
Ryan and Ms. Rivlin, could save $180 billion over 10 years. House Republicans could save an additional $434
billion by eliminating the expansion in Medicaid eligibility scheduled to take place in 2014 under the new health
care law.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
Graphical Approach
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
Elasticities Determine Tax Inefficiency
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
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; deadweight loss is
caused by individuals and firms making inefficient consumption and
production choices in order to avoid taxation.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
Efficiency Effects of a Fertilizer Tax:
Example
D for Fert:
Qd=240-6P
S of Fert:
Qs=-60+4P
A $4 tax is imposed on fertilizer producers
Illustrate the effect of this tax on producers
Find the initial and new equilibrium pts
Calculate the DWL
Find producer and consumer share
What is the revenue generated?
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency

APPLICATION
Tax Avoidance in Practice
1. The British boat designer Uffa Fox lived in a home he constructed from a
floating bridge. When the Inland Revenue (Britain’s tax collectors)
attempted to collect property tax on the home, Fox began sailing it up and
down the river. By the time he was done, Fox had collected so many
different addresses that the Inland Revenue gave up their attempts.
2. An Englishman visiting Cyprus in the early 1980s asked a tour guide why
so many of the houses seemed to have steel reinforcement bars jutting out
from their top floors. The guide informed him that Cyprus had a building
tax that applied only to finished structures. Owners of those houses could
thus claim that they were still in the process of finishing the roof.
3. The Thai government levies a tax on signs in front of businesses. The tax is
levied only on external signs and the rate depends on whether the sign is
completely in Thai (low), in Thai and English (medium), or completely in
English (very high). A walk around Bangkok thus reveals many businesses
hanging English signs with a small amount of Thai writing in the upperright-hand corner. Some businesses manage to avoid the tax entirely by
printing the message on curtains that are hung in the front window,
rendering the sign “internal” and thus tax-exempt.

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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
The real tax avoidance scandal centers on dividends
and capital gains By Robert J. Samuelson, Sunday, April 3, 7:53 PM
GE $14 billion, no taxes
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
Determinants of Deadweight Loss
The formula for DWL is
1 sd
Q
2
DWL  
 
2( s d )
P
where d is theelasticityof demand,
 s is theelasticityof supply,
and is the tax rate.
marginal deadweight loss
The increase in deadweight
loss per unit increase in the tax.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
Determinants of Deadweight Loss
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
Deadweight Loss and the Design of Efficient Tax Systems
A Tax System’s Efficiency Is Affected by a Market’s
Preexisting Distortions
preexisting distortions Market failures, such
as externalities or imperfect competition, that are
in place before any government intervention.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
Deadweight Loss and the Design of Efficient Tax Systems
A Tax System’s Efficiency Is Affected by a Market’s
Preexisting Distortions
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
Deadweight Loss and the Design of Efficient Tax Systems
Progressive Tax Systems Can Be Less Efficient
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
Deadweight Loss and the Design of Efficient Tax Systems
Progressive Tax Systems Can Be Less Efficient
Why is the deadweight loss larger for the higher-wage worker
despite the same reduction in hours worked? Because in a competitive labor
market, the wage rate equals the marginal product of labor, so the highwage worker has a higher marginal product of labor. As a result, society
loses more efficiency when the high-wage worker reduces her hours (at a
marginal product of $20 per hour) than when the low-wage worker reduces
her hours (at a marginal product of $10 per hour).
The guiding principle for efficient taxation is to create a broad and level
playing field rather than taxing some groups or goods particularly highly
and others not at all.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
Deadweight Loss and the Design of Efficient Tax Systems
Governments Should “Smooth” Tax Rates Over Time
Just as individual utility is maximized by full consumption smoothing,
government efficiency in taxation over time is maximized by tax
smoothing, by having a relatively constant tax rate over time rather than
high taxes in some periods and low taxes in others.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency

APPLICATION
The Deadweight Loss of Taxing Wireless Communications
Hausman (2000) estimated the deadweight loss from a particularly dynamic
sector of our economy: wireless communications services:
• In 1999, the state and federal tax burden on wireless communication in the
typical state was 14.5%, although the rate was 25% in high-tax states.
• Hausman estimated that for every dollar the government raised in taxes,
social welfare was reduced by 53¢.
This figure is high for three reasons:
• Demand for wireless communications is fairly price sensitive.
• There is already a large preexisting distortion in this market.
• The taxes are fairly high, and the marginal deadweight loss rises with the
tax rate.
Hausman estimated that the marginal deadweight loss caused by an additional
tax on wireless services ranged from 72¢ to 90¢ per dollar raised.

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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.2
Optimal Commodity Taxation
Ramsey Taxation: The Theory of Optimal Commodity Taxation
optimal commodity taxation Choosing the tax rates
across goods to minimize deadweight loss for a given
government revenue requirement.
Ramsey Rule To minimize the deadweight loss of a
tax system while raising a fixed amount of revenue,
taxes should be set across commodities so that the
ratio of the marginal deadweight loss to marginal
revenue raised is equal across commodities.
value of additional government revenues The value
of having another dollar in the government’s hands
relative to its next best use in the private sector.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.2
Optimal Commodity Taxation
Inverse Elasticity Rule
If we assume that the supply side of commodity markets is perfectly
competitive (elasticity of supply is infinite), then the Ramsey result implies
that

where i is theoptimaltaxratefor commodityi, andiis theelasticityof demandfor commodityi.
This formulation of Ramsey’s rule shows that two factors must be
balanced when setting optimal commodity taxes:
 The elasticity rule: When elasticity of demand for a good is high, it
should be taxed at a low rate; when elasticity is low, the tax rate
should be high.
 The broad base rule: It is better to tax a wide variety of goods at a
moderate rate than to tax very few goods at a high rate. Because the
marginal deadweight loss from a tax rises with the tax rate, the
government should spread taxes across a large number of commodities
and not tax any one commodity at a very high rate.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.2
Optimal Commodity Taxation
Equity Implications of the Ramsey Model
Imagine that the government had only two goods it could tax, cereal and
caviar:
• The elasticity of demand for caviar is much higher than that for
cereal, so the inverse elasticity rule would suggest that the
government tax cereal much more highly than caviar.
• This would mean imposing a tax on a good consumed exclusively by
higher-income groups that was much lower than the tax imposed on a
good consumed by all.
This outcome, while efficient, might violate a government’s sense of tax
fairness across income groups (vertical equity).
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.2
Optimal Commodity Taxation

APPLICATION
Price Reform in Pakistan
Angus Deaton (1997) studied the demands for commodities in several
developing nations. He used variation in prices encountered by consumers of
rice, wheat, and other commodities to estimate their elasticities of demand.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.2
Optimal Commodity Taxation
Efficiency Consequences
of Subsidies and Taxes in
Pakistan • In panel (a), the
market for wheat, demand is
fairly inelastic and supply is
subsidized, leading quantity
to increase from Q1 to Q2 with
a deadweight loss of BAC. In
panel (b), the market for rice,
demand is very elastic, so
when supply is subsidized the
quantity rises by much more
(from Q1 to Q2), and the
deadweight loss is larger
(BAC). In panel (c), the
market for oils and fats,
demand is also very elastic,
so even the small tax leads to
a large reduction in quantity
from Q1 to Q2, with a
deadweight loss of BAC.
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
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.3
Optimal Income Taxes
optimal income taxation Choosing
the tax rates across income groups to
maximize social welfare subject to a
government revenue requirement.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.3
Optimal Income Taxes
General Model with Behavioral Effects
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.3
Optimal Income Taxes
General Model with Behavioral Effects
The optimal income tax system meets the following condition:
set incometax ratesacrossgroupssuch thatMUi MRi  
Where MU is the marginal utility of individual i,
MR is the marginal revenue raised from taxing that individual,
and 
is the value of additional government revenues.
In the case of income taxation, the optimal tax system reflects a different
balancing:
 Vertical Equity: Social welfare is maximized when those who have a
high level of consumption, and thus a low marginal utility, are taxed
more heavily, and those who have a low level of consumption, and thus
a high marginal utility, are taxed less heavily.
 Behavioral Responses: As taxes rise on any one group, individuals in
that group may respond by earning less income.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.3
Optimal Income Taxes
An Example
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.4
Tax-Benefit Linkages and the Financing of Social
Insurance Programs
tax-benefit linkages Direct ties between
taxes paid and benefits received.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.4
Tax-Benefit Linkages and the Financing of Social
Insurance Programs
The Model
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.4
Tax-Benefit Linkages and the Financing of Social
Insurance Programs
Issues Raised by Tax-Benefit Linkage Analysis
If There Is No Inefficiency to Providing a Benefit, Why
Doesn’t the Employer Just Do So Without
Government Involvement?
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.4
Tax-Benefit Linkages and the Financing of Social
Insurance Programs
Issues Raised by Tax-Benefit Linkage Analysis
When Are There Tax-Benefit Linkages?
The tax-benefit linkage is strongest when taxes paid are linked directly
to a benefit for workers.
What Is the Empirical Evidence on Tax-Benefit Linkages?
The existing literature suggests that the cost of social insurance
financing is borne by workers in the form of lower wages and not lower
employment.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.4
Tax-Benefit Linkages and the Financing of Social
Insurance Programs
EM P I R I C A L E V I D E N C E
A GROUP-SPECIFIC EMPLOYER MANDATE
Gruber (1994) examined the impact on wages and labor supply of a groupspecific mandated benefit.
Before the mid-1970s, health insurance plans provided very little coverage for
the costs associated with normal pregnancy and childbirth. This was viewed as
discriminatory by some state governments, leading to the state laws mandating
that pregnancy costs be covered as completely as other medical costs.
These laws significantly increased the insurance costs for women of
childbearing age in those states, thereby raising the costs of employing a
specific group of workers (treatment group). There were two possible control
groups: similar workers in other states that did not pass these laws, or other
groups of workers within the states that did pass these laws.
Gruber’s study compared the changes in wages and labor supply of the
treatment group around the time of the passage of these laws to the changes in
both of these control groups.
The results show that the cost of this new mandate was fully passed on to the
wages of the affected groups, with little effect on their labor supply.
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CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.5
Conclusion
The fundamental issue in designing tax policy is the equity-efficiency tradeoff.
Understanding tax efficiency really comes down to remembering two key
principles:
• The more elastically supplied or demanded the good, the larger the
deadweight loss from the tax.
• The higher the tax rate, the larger the incremental deadweight loss of
taxation.
Trading off these two considerations is the key to understanding the
efficiency aspects of the tax policies.
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