Points on optimal taxation
There has been a lot of talk about tax (eg here).
When thinking about tax systems it is useful to run the following train of thought for optimal design:
- Start with a target level of government spending. Goal is to raise this revenue at the lowest cost to society.
- First start with taxes which improve the allocation of resources by correcting a market failure (externality taxes).
- Then design a nice flat tax (either on all income or consumption) which treats everything equally.
- Then shift relative taxes in broad areas based on the long-run elasticity of supply and demand, and constrained by the potential for tax avoidance (Ramsey principle).
Once this initial tax system has been designed, and government spending has been sorted we face a clear “equality-efficiency” trade-off.
In a final step we then adjust the progressivity of the tax system, or the type of government welfare spending, in order to achieve the type of trade-off between these factors that society desires.
Now this doesn’t tell us what the scheme should be, but it allows us to directly look at the trade-offs we are making and make a clear decision. If the goal is to make fiscal policy that represent the preferences of society at the lowest cost this is the way we need to think about it – instead of saying “more growth”, “more redistribution”, “more tax on land/capital/houses/consumption” etc etc without thinking about it in general terms.
Furthermore, even when we come up with a scheme based on this train of thought we only get told what would be optimal “in the long run”. The required transition path for the tax system from now until then is still far from clear.