Optimal Taxation Flashcards
what concept is the optimal taxation based on?
on laffer’s curve, which shows that there is an optimal tax rate that brings the most revenue. it’s a concept bc it doesn’t hold in reality.
What is the substitution effect?
= change in quantity of the taxed good if the happiness level would stay the same after tax being introduced.
it happens when the price of a good changes (bc of tax)
https://mnmeconomics.files.wordpress.com/2012/01/incsubs4.png
1. in a market with two goods (x and AOG), we tax only one (x).
2. budget line B1 shifts to B2. with it, also
the indifference (blue) curve shifts left. we go from point A to point B.
3. if we imagine the B2 shift to the first indifference curve (so we have the same happiness), we can measure how much of the change in Q of x (and AOG) is due to the substitution effect.
it results in higher consumption of AOG and lower of X.
what is the income effect?
happens whenever a tax is introduced and is a consequence of reduction of real income
https://mnmeconomics.files.wordpress.com/2012/01/incsubs4.png
when one good is taxed, the budget curve and indifference curve shift. the current reality (point B) shows how much we actually consume with our income.
total effect - substitution effect = income effect
what is the goal of optimal taxation?
to have parallel budget lines.
Why? If the budget line is parallel to the before-tax one, we can get the same amount of tax revenue while making the customer happier (since the indifference curve 2 is more to the right than 1).
https://www.economicsdiscussion.net/wp-content/uploads/2016/09/clip_image002-42.jpg
why is optimal taxation not realistic?
because we would need to tax ALL goods, including leisure (free time). that would be hyper-tryanical.
is income tax optimal? explain.
no.
the budget lines are not parallel, so there is substitution effect. because of that, the taxation is not optimal (there is excess tax burden = DWL).
is VAT optimally taxed? explain.
no.
slope is again changed (of the budget line), which means there is substitution effect and the taxation is not optimal.
what is the next best option for near-optimal taxation since we cannot tax ALL goods?
ramsay rule, which states that goods should be taxed in inverse proportion to their elasticity of demand.
e.g. D is inelastic -> small DWL -> should be taxed
(gov wants to minimise the DWL that happens bc of change in behaviour)
what is the problem of the ramsay rule?
goods with inelastic demand are often necessities. if these would be taxed more, the less-wealthy people (that spend most of their money only on necessities) would be hurt way more than wealthy people that spend only a small portion of their income on necessities.
what is the solution of the ramsay rule?
the corlett-hague’s rule, which states that the goods that complement leisure (but are NOT leisure, since we can’t tax that) (so the goods that are not necessities) should be taxed (not the necessities).
this reduces the desirability of leisure (since prices are higher) and thus reduces labour market distortion.
state the ramsay rule.
λ = MDWL / MR
MDWL = ΔDWL / Δt
MR = ΔR / Δt
(both are derivatives ;))
how much will the cumulative DWL increase if we increase revenue target R?
