Public 4: Second Best Flashcards
What is a ‘first-best world’?
In a first-best world, the only constraint on interventions is the resource constraint: we cannot consume more than we produce or have saved. Lump-sum taxation, observation of all relevant information, and any policy instrument are possible.
Therefore, any market distortions can be completely corrected using the correct instrument.
Why is it not generally optimal for governments to minimise deadweight loss in each individual market separately?
Suppose there is a distortion in one market. This will affect other markets through interdependencies, and can be addressed using tools in other markets. Since deadweight loss tends to grow more than proportionally with the size of a distortion, it is usually optimal to spread these distortions across markets.
Explain why subsidising substitutes of a good with negative externalities that we cannot impose a Pigouvian tax may be a good idea.
The first-best solution would be to impose a Pigouvian tax, reducing the quantity produced to the point where marginal social benefit equals marginal social cost.
Subsidising substitutes of this good will also result in a quantity decrease, and so deadweight loss is again reduced.
Explain an example of ‘second-best policy’ in the case of a monopolist.
Suppose a private monopolist produces good x and sells above marginal cost. If we cannot encourage competition or regulate the monopolist to p_x=MC_x, we could subsidise substitutes for x or tax its complements.
Should public monopolies price at marginal cost?
No. Setting p=MC will result in losses, since for natural monopolies there are high fixed costs to cover. In a first-best world, this loss could be paid for with lump-sum taxes. However, in a second-best world, we will have to distort other markets when raising taxes. We should therefore use Ramsey pricing and minimise overall distortion, which will involve pricing above marginal cost in the public monopoly.
What is the production efficiency result?
Suppose goods are produced in a competitive market with constant returns to scale. Then, Diamond and Mirrlees (1971) show that taxes should only be levied on final, not intermediate goods.
Myles (1989) shows that this also holds for imperfect competition and decreasing returns to scale, assuming all technologies are Leontief.
Under Diamond-Mirrlees, should we impose tariffs?
No, since importing and exporting are not final sales. These are just parts of the production process and should not be taxed.
Why do developing countries use tariffs much more than developed countries?
Tariffs are some of the easiest taxes to administer and some of the hardest to evade. If a country has limited state capacity and/or significant problems with evasion (as many developing countries do, due to eg large rural informal sectors), tariffs may be a third-best way of ensuring any revenue is collected at all.
How does noncompliance affect the optimal balance of income and commodity taxes?
If compliance is full, the Atkinson-Stiglitz theorem implies that a zero commodity tax rate is optimal, subject to the Corlett-Hague caveat.
However, commodity taxes are much harder to evade than income taxes. Therefore, if noncompliance is a concern, we may prefer a mix of income and commodity taxes.
How does international tax competition affect the optimal corporation tax rate?
International tax competition decreases the optimal corporation tax rate to the extent that multinational corporations are sensitive to corporation tax changes and the benefits that multinational corporations bring to a country. This is tempered by the ‘global minimum tax rate’.
How does tax noncompliance affect the equity properties of the tax system?
If higher and lower earners have different opportunities to evade taxes, the formal redistributive properties of the tax system may not be realised. This could go in either direction. For example, we might think that in informal economies low earners can avoid income taxes more easily than higher-paid office workers, making taxes more progressive than we would otherwise think. However, we might also think that the wealthy have more ability to move income offshore, take it in different forms and times, and have greater access to tax consultants that allow them to minimise their tax liability. This would imply that the tax system is less progressive than it appears.
Horizontal equity concerns also apply. For example, if the self-employed can more easily evade taxes than employed workers, the tax system is relatively inequitable in favour of the self-employed.
How should equity objectives be achieved in the presence of noncompliance?
- Try to improve compliance; improve detection, tighten loopholes, increase penalties.
- Use a variety of taxes rather than a narrow range that is easily avoided
- Monitor and regulate the tax consultancy industry
- Although vertical equity is important, if there were a systematic relationship between income and noncompliance we could simply adjust marginal rates to achieve whatever degree of progressivity we wanted. It is horizontal equity that will be important. The existence of evasion means that people with similar incomes have different tax burdens - the definition of horizontal inequity.
Do the wealthy evade taxes more than the poor? Why? How do we know?
Recent evidence suggests that the wealthy evade more taxes than lower earners in both absolute and proportionate terms. This can be due to political power, greater financial literacy, and more international mobility.
However, some theory pulls in the other direction: it is more worth it for evasion detectors to focus on high earners, so probability of detection is higher, so the wealthy may be expected to evade taxes less. Some claim that “the poor evade and the rich avoid”; that is, the rich find legal loopholes, rather than evading taxes illegally. Other evidence shows that evasion rates in fact follow a U-shape: the very poorest and the very richest evade the most.
