20

CHAPTER 20:

Tax Inefficiencies
and Their
Implications for
Optimal Taxation
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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

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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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Introduction

Arnold Harberger, one of the pioneers of the general equilibrium

tax incidence model, wrote of his experience in Indonesia, where
cars are taxed more heavily than motorcycles.
• “Three-wheel cycles were converted, by artful additions, into virtual buses, or at least
taxis. Sometimes a single bench was added, with the passenger looking backward.
Other times the cycle was stretched at the back, with two benches going down each
side, and maybe even with an extra little running board cutting laterally across the
rear (where the rear bumper of the car would be). I must say I was truly astounded
when I saw my first eight-passenger motorcycle.”

This example highlights a simple fact: markets do not take taxes

lying down. If there is some action that market participants can
undertake to minimize the burden of taxation, they will do so.

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Taxation and Economic Efficiency 1

• Usually, the market produces efficient outcomes.

• Taxes interfere in the market and reduce efficiency.
• People substitute away from the taxed product, using less
efficient alternatives.
o Eight-person motorcycles in Indonesia
• Some taxes have much larger efficiency costs than others.

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Taxation and Economic Efficiency 2: Graphical Approach

Figure 20-1

A tax is imposed, and supply shifts from S1 to S2. Deadweight loss occurs—triangle BAC.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Taxation and Economic Efficiency 3

• Absent taxes:
price = social marginal benefit = social marginal cost
• The tax drives a wedge between SMB and SMC, preventing
mutually beneficial trades from occurring.
• The units between 90 and 100 would have generated a
consumer and producer surplus.
• The forgone surplus from taxation is called the deadweight loss
(DWL).
• The size of the DWL depends on elasticities.

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Elasticities Determine Tax Inefficiency 1

Figure 20-2

The deadweight loss of a given tax is smaller when the demand curve is less elastic than
when it is more elastic.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Elasticities Determine Tax Inefficiency 2

• Deadweight loss is caused by individuals and firms making

inefficient consumption and production choices in order to
avoid taxation.
• The inefficiency of any tax is determined by the extent to which
consumers and producers change their behavior to avoid the
tax.
• The more elastic is demand or supply, the larger the DWL.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Empirical Evidence: The Window Tax 1

In 1696, English King William III needed money to finance an

ongoing war with France.
• To raise this revenue, the king imposed a new tax based on the
number of windows in a home, which was an indicator of a
home’s value: more valuable homes would have more windows
and therefore be taxed more highly.
• The problem was that individuals could minimize their tax by
boarding up or otherwise removing windows. This rendered the
tax a less efficient measure of home value and created a
deadweight loss by making it less pleasant (and therefore of
less value to residents) to live in their homes.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Empirical Evidence: The Window Tax 2

Oates and Schwab (2015) presented a straightforward test for

whether this was the case: they looked at whether the number of
windows responded to “notches” in the tax schedule.
• From 1747 to 1757, there was no tax if the house had fewer
than ten windows, a tax of 6 pence per window for 10 to 14
windows; a tax of 9 pence per window if there were 15 to 19
windows; and a tax of 1 shilling (12 pence) per window for 20
windows or more.
• The marginal tax rate jumped enormously on building the 10th,
15th, or 20th window.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Empirical Evidence: The Window Tax 2

Oates, Wallace E., and Robert M. Schwab. 2015. "The Window Tax:
A Case Study in Excess Burden." Journal of Economic
Perspectives, 29 (1): 163-80.

https://www.aeaweb.org/articles?id=10.1257/jep.29.1.163
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2921077

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Empirical Evidence: The Window Tax 3

Figure 20-3

There are obvious spikes at 9, 14, and 19 windows, exactly what we would
predict from the effects of this tax.
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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Empirical Evidence: The Window Tax 4

One could argue that perhaps there was some British custom or
some other reason for having 9, 14, or 19 windows in a house.
• Oates and Schwab address this point by using the fact that in
1761, the government added a provision that houses with 8 or
9 windows would pay 1 shilling per window.
• This means that after 1761, there was suddenly an incentive to
keep the number of windows to 7 or fewer. This is exactly what
happened.

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Empirical Evidence: The Window Tax 5

Figure 20-4

In data from 1761 to 1765, the authors find that 27% of houses have 7 windows,
while only 5% have 6 windows, and 3% have 8 windows. This is a ninefold
increase from the 3% of buildings with 7 windows from just a few years earlier.
Clearly, this was a response to the tax.
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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

APPLICATION: Tax Avoidance in Practice

Keynes: “The avoidance of taxes is the only pursuit that still carries
any reward.” Some examples of avoidance:
1. The Papal States taxed salt heavily, so Tuscan bakers stopped
using it. Even today, Tuscan bread is saltless.
2. In the early 1980s, Cyprus’s building tax applied to finished
structures. Homeowners put steel bars jutting out from their
roofs to avoid the tax.
3. Thailand taxes business signs on the outside, with higher taxes
for English-only signs. So, many signs have a bit of Thai writing
in the corner or are hung on curtains inside the shop.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Determinants of Deadweight Loss 1

• The Harberger Formula for

• DWL = (1/2) · t · ∆Q
𝜂𝑠 𝜂𝑑 2
𝑄
𝐷𝑊𝐿 = − ×𝜏
2 𝜂𝑠 − 𝜂 𝑑 𝑃

• DWL rises with the square of the tax, so marginal DWL rises
with the tax rate.
o 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

Determinants of Deadweight Loss 2

Figure 20-5

The marginal deadweight loss rises disproportionately with the tax rate.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

A Tax System’s Efficiency Is Affected by a Market’s

Preexisting Distortions 1
• Since marginal DWL rises with the tax rate, preexisting
distortions affect the efficiency of a new tax.
o 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

A Tax System’s Efficiency Is Affected by a Market’s

Preexisting Distortions 2
Figure 20-6

A tax in a market with no preexisting distortions creates a deadweight loss equal

to triangle BAC. A positive externality in the market has created a deadweight
loss triangle EDF; imposing a tax on this market results in a deadweight loss that
is larger by the area of trapezoid GEFH.
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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Progressive Tax Systems Can Be Less Efficient 1

• Because the DWL rises with 𝜏 2 , progressive tax systems can be

less efficient than proportional ones.
• Example:
• Suppose there are two people, one with a wage of $10 per
hour and one with a wage of $20 per hour.
• For both, a 10% rise in wages leads them to supply 10%
more labor (elasticity of labor supply = 1).
• Elasticity of labor demand is also 1.

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Progressive Tax Systems Can Be Less Efficient 2

Why is the deadweight loss larger for the higher-wage worker

despite the same reduction in hours worked?
• In a competitive labor market, wage equals the marginal
product of labor, so the high-wage worker has a higher marginal
product of labor.
• Society loses twice as much when the high-wage worker reduces
her hours than when the low-wage worker reduces her hours.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Progressive Tax Systems Can Be Less Efficient 3: Graphical

Approach Figure 20-7

Initially the government imposes an equal tax on the low-wage worker and the
high-wage worker, which results in deadweight losses of triangles BAC and EDF.
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Progressive Tax Systems Can Be Less Efficient 4: Graphical

Approach Figure 20-7

When system is replaced with no tax on low-wage workers, there is no DWL for
this worker, but the DWL for the high-wage worker increases by the trapezoid
GEFI. This results in an increase in deadweight loss because additional taxes
must be collected from high-wage workers in order to collect the same
revenues as before.

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Progressive Tax Systems Can Be Less Efficient 5

Low-Wage Worker High-Wage Worker

(panel a) (panel b)
Tax Rate Tax Rate Hours Deadweight Hours Deadweight Total
Below Above of Labor Loss from of Labor Loss from Deadweight
$10,000 $10,000 Supply Taxation Supply Taxation Loss
No tax 0 0 1,000 (H1) 0 1,000 (H1) 0 0

Proportional 20% 20% 894 (H2) $115.71 894 (H2) $231.42 $347.13
tax (area BAC) (area EDF) (BAC + EDF)
Progressive 0% 60% 1,000 (H1) 0 837 (H3) $566.75 $566.75
tax (area GDI) (EDF + GEFI)

The deadweight loss is larger for the higher-wage worker despite the same
reduction in hours worked.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Governments Should “Smooth” Tax Rates over Time

• 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.
• High and then low tax rates produce a larger DWL then steady
medium tax rates.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

APPLICATION: The Deadweight Loss of Taxing Wireless

Communications

• Hausman, Jerry. "Efficiency Effects On The U.S. Economy From

Wireless Taxation," National Tax Journal, 2000, v53(3,Sep), Part
2, 733-942.

o https://www.nber.org/papers/w7281.pdf
o https://economics.mit.edu/files/1029

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APPLICATION: The Deadweight Loss of Taxing Wireless

Communications
• Hausman (2000): The DWL from taxes on wireless
communications equals 53% of revenue.
• This figure is high for three reasons:
o High price sensitivity (elastic demand).
o Large preexisting distortions from imperfect competition.
o High taxes—25% in some states, and in those states, the
DWL is even higher.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal 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,
𝑀𝐷𝑊𝐿𝑖
that is, = 𝜆.
𝑀𝑅𝑖

• 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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Inverse Elasticity Rule

• If supply is infinitely elastic, the Ramsey Rule becomes:

∗ 1
𝜏𝑖 = − × 𝜆
𝜂𝑖
o 𝜏𝑖∗ is the optimal tax, 𝜂𝑖 is the elasticity of demand, and 𝜆 is
some constant.
• Optimal taxation therefore balances two rules:
o Elasticity rule: Lower taxes on goods with more elastic
demand.
o Broad base rule: Better to tax a wide variety of goods
moderately than few goods heavily.

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Equity Implications of the Ramsey Model

Imagine that the government had only two goods it could tax:
cereal and caviar:
• Elasticity of demand for caviar is much higher than that for
cereal.
• The inverse elasticity rule would suggest that the government
tax cereal much more highly than caviar.
• This means taxing more heavily the good consumed by poor
people.
• This might hurt vertical equality.

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APPLICATION: Price Reform in Pakistan

• Commodities are taxed or subsidized throughout the

developing world.
• Deaton (1997) studied the demand for subsidized goods in
Pakistan, looking at their elasticity and the income of people
who consume it.
Table 20-1

Price Policy Welfare Include Distribution

Good Subsidy
Elasticity Change Gain Concerns

Wheat 40% −0.64 Reduce Small Don’t reduce subsidy

subsidy
Rice 40% −2.08 Reduce Large Reduce subsidy
subsidy
Oil/fat −5% −2.33 Reduce tax Large Reduce tax further

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APPLICATION: Efficiency Consequences of Taxes and :

Wheat (Inelastic Demand)
Figure 20-8(a)

In 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.

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APPLICATION: Efficiency Consequences of Subsidies : Rice

(Elastic Demand)
Figure 20-8(b)

In 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).

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APPLICATION: Efficiency Consequences of Taxation : Oils

and Fats (Elastic Demand)
Figure 20-8(c)

In the market for oils and fats, demand is also very elastic, so even a small tax leads
to a large reduction in quantity from Q1 to Q2, with a deadweight loss of BAC.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Learn by Doing: Practice Question 1

Which of these are TRUE concerning taxation?
I. The inefficiency of a tax is determined by the elasticities of supply
and demand.
II. Taxing a good that has a negative externality generates
deadweight loss.
III. Progressive tax systems tend to be less efficient than proportional
tax systems.
a) I and II only
b) I and III only
c) II and III only
d) I, II, and III
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Learn by Doing: Practice Question 1 (Answer)

Which of these are TRUE concerning taxation?
I. The inefficiency of a tax is determined by the elasticities of supply
and demand.
II. Taxing a good that has a negative externality generates
deadweight loss.
III. Progressive tax systems tend to be less efficient than proportional
tax systems.
a) I and II only
b) I and III only (correct answer)
c) II and III only
d) I, II, and III
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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Optimal Income Taxes

• Most tax revenue in the United States and other developed

countries is from income taxes.
• Optimal income taxation: Choosing the tax rates across
income groups to maximize social welfare subject to a
government revenue requirement.
• Social welfare function guides the trade-off between
progressivity and efficiency.

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

A Simple Example 1

1. Everyone in society has the same utility functions:

𝑈1 = 𝑈2 = …
2. These utility functions exhibit diminishing MU of income.
3. Total income in society is fixed, not determined by individual
choices that might respond to tax rates.
4. Society has an equally weighted utilitarian social welfare
function:
𝑉 = 𝑈1 + 𝑈2 + . . .

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A Simple Example 2

Under these assumptions:

• The optimal income tax system is one that leaves everyone with
the same level of post-tax income.
• People with income below average would receive a transfer to
increase their incomes to average.
• The marginal tax rate under this system is 100%.
• If income responds to taxes, the optimal marginal tax rate is
lower.

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General Model with Behavioral Effects 1

• With behavioral effects, taxes reduce hours worked.

o At high tax rates, tax revenue falls with the tax rate; no one
works under a 100% tax rate.
• The optimal tax system trades off the efficiency cost of taxation
against the benefits of redistribution.
• The rule is to set the income for group 𝑖 such that
𝑀𝑈𝑖
=𝜆
𝑀𝑅𝑖
• 𝑀𝑈𝑖 is MU for group 𝑖, 𝑀𝑅𝑖 is the marginal revenue, and 𝜆 is
the value of government revenue.

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The Laffer Curve

Figure 20-9

As tax rates rise from 0 to τ*, tax revenues rise, but when tax rates rise above τ*
toward 100%, tax revenues fall.

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General Model with Behavioral Effects 2

Optimal income taxation balances:

• 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 when 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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An Example: Optimal Income Taxes with Two Types

Figure 20-10

The ratio of marginal utility to marginal revenue rises as tax rates rise for any
taxpayer, but this ratio for Mr. Rich is everywhere below the ratio for Ms. Poor.
Optimal income tax rates are those that equate this ratio across taxpayers.
Here, the optimal rates are 10% for Ms. Poor and 20% for Mr. Rich.
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Tax-Benefit Linkages and the Financing of Social Insurance

Programs
• So far, we have ignored tax-benefit linkages.
• Tax-benefit linkages: Direct ties between taxes paid and
benefits received.
• Introducing these linkages changes the story since many payroll
taxes are directly linked to benefits.

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Tax-Benefit Linkages: Graphical Representation

Figure 20-11

A pure tax on labor would shift the demand curve from D1 to D2 and create the
deadweight loss triangle CAB. If those taxes are tied to benefits provided to
workers, then supply shifts out to S2. Labor supply falls only to L3, and the
deadweight loss triangle shrinks to GAF.
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Perfect Linkage Eliminates the DWL

Figure 20-12

When workers value the tax-financed benefit so highly that they are willing to
accept its full cost in lower wages, there is no change in employment when the
tax is imposed.

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Issues Raised by Tax-Benefit Linkage Analysis

• Why doesn’t the private sector provide these benefits?

o Market failures may plague the market.
• When are there tax-benefit linkages?
o The tax-benefit linkage is strongest when taxes paid are
linked directly to a benefit for workers.
• What is the evidence on tax-benefit linkages?
o Financing is borne by workers in the form of lower wages
and not lower employment.

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EVIDENCE: A Group-Specific Employer Mandate

• In the mid-1970s, states began to mandate insurance benefits

for pregnant women.
• These laws raise the cost of insuring and hence employing
certain groups.
• Compared to other groups in the same states or the same
groups in states without mandated benefits:
o Wages fell.
o Labor supply did not.
• This suggests that benefit linkage is near complete.

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Learn by Doing: Practice Question 2

Which of these are TRUE concerning taxation?

I. Raising taxes raises tax revenues.
II. Optimal income taxation equalizes the ratio of marginal utility to
marginal revenue for all individuals.
III. When tax-benefit linkage exists, deadweight loss is reduced.
a) I and II only
b) I and III only
c) II and III only
d) I, II, and III

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 CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Learn by Doing: Practice Question 2 (Answer)

Which of these are TRUE concerning taxation?

I. Raising taxes raises tax revenues.
II. Optimal income taxation equalizes the ratio of marginal utility to
marginal revenue for all individuals.
III. When tax-benefit linkage exists, deadweight loss is reduced.
a) I and II only
b) I and III only
c) II and III only (correct answer)
d) I, II, and III

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Conclusion

• The fundamental issue in designing tax policy is the equity-

efficiency trade-off.
• Tax efficiency comes down to two key principles:
o The more elastically supplied or demanded the good, the
larger the deadweight loss from the tax.
o The higher the tax rate, the larger the incremental
deadweight loss of taxation.

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