Section

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Section 9 (c)
A Framework for Tax AnalysisEfficient and
Equitable Taxation
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Optimal Commodity Taxation

• How should a tax system be designed if it is to
  yield efficient an fair outcomes?

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Optimal Commodity Taxation

• The goal of optimal commodity taxation is to
  select tax rates on a basket of commodities in
  such a way that the excess burden of raising the
  required tax revenue is as low as possible.
• The challenge in reaching an optimal commodity
  taxation regime is complicated by the
  understanding that neutral taxation is not
  efficient.

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The Ramsey Rule

• To minimize the total excess burden, tax rates
  should be set so that the tax-induced percentage
  reduction in the quantity demanded of each
  commodity is the same.

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The Ramsey Rule

• Recall that excess burden minimization requires
  information on the marginal excess burden on the
  last dollar of revenue collected.
• Hence, to minimize total excess burden, tax rates
  should be set so that the percentage reduction in
  the quantity demanded of each commodity is the
  same.

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The Ramsey Rule

• To minimize total excess burden requires that all
  these changes be in the same proportion.

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Inverse Elasticity Rule

• This rule states that as long as goods are
  unrelated in consumption, tax rates should be
  inversely proportional to elasticities.
• That is, the higher the elasticity of a
  commodity, the lower its tax rates should be, and
  vice versa.

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Inverse Elasticity Rule

• One of the goals of taxation is to create as
  little distortion as possible.
• However, the potential for distortion is greater
  the more elastic the demand for a commodity.
• Therefore, efficient taxation requires that
  relatively high rates of taxation be levied on
  relatively inelastic goods.

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Equity Considerations

• Another criterion to a tax system, which is
  sometimes counter to efficiency, is fairness.
• Most agree that tax systems should have some
  sense of vertical equity to them (distributes
  burdens fairly across people with different
  abilities to pay).

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Equity Considerations

• Consider the example of Bread!

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Equity Considerations

• Equity considerations therefore require a
  departure, sometimes, from the Ramsey Rule,
  depending on the following
• The strength of societys egalitarian
  preferences.
• The extent to which the consumption patterns of
  the rich and poor differ.

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Questions?