Transcript INDIRECT TAXATION

THE THEORY OF OPTIMAL TAXATION:
NEW DEVELOPMENTS AND
POLICY RELEVANCE
Peter Birch Sørensen
University of Copenhagen,
EPRU and CESifo
Invited Plenary Lecture
20th Scientific Meeting of SIEP, Pavia, September 2008
PRELIMINARIES
The optimal tax revolution:
theorists versus practitioners
An irrelevant objection to optimal
tax theory: The straw man of the
’benevolent dictator’
Optimal
indirect taxation
INDIRECT TAXATION: THE
UNIFORM-TAX CONTROVERSY
Suppose a certain amount of revenue has
to be raised from indirect taxation. The
issue then arises:
Should indirect taxes be differentiated?
Optimal tax theory: Generally Yes!
Practitioners: No!
(Note: Uniform indirect taxation is
equivalent to having no indirect taxation
at all)
RAMSEY TAXATION
The optimal indirect tax system causes an equiproportionate reduction in the compensated
demands for all commodities
The Corlett-Hague rule
Impose relatively high tax rates on commodities
that are complements to (less substitutable for)
leisure
NB: Implementing the optimal tax system requires
knowledge of compensated own-price and crossprice elasticities
THE CASE FOR UNIFORM TAXATION
Separable preferences (all commodities equally
substitutable for leisure)
Uniform taxation easier to administer and less
susceptible to fraud
Ramsey taxation requires frequent tax rate
changes due to changes in tastes and
technology
Differentiated taxation invites lobbyism
A MODEL WITH HOUSEHOLD PRODUCTION
(Kleven, Richter and Sørensen, OEP, 2000)
Consumers get utility from goods, services and
leisure
All goods are bought in the market; services can
be produced in the home or can be delivered from
the market
Time can be spent on home production, market
production or leisure
The government levies taxes on commodities and
on labor income
OPTIMAL TAXATION WITH
HOUSEHOLD PRODUCTION
• The optimal tax system causes an equiproportionate reduction in the compensated
demands for all market-produced goods and
services
• If home production is large, it may be optimal to
tax consumer services at a relatively low rate even if
they are complements to leisure
• If all goods and services are equally substitutable
for leisure (so that uniform taxation would be
optimal in the absence of home production), it is
certainly optimal to tax consumer services at a low
rate
OPTIMAL TAXATION WITH
HOUSEHOLD PRODUCTION
• Taxes should distort the pattern of market activity
as little as possible
• A high tax on complements to leisure may not be an efficient
way of stimulating labour supply to the market if such a tax
encourages substition of home production for market production
• Untaxed home production tends to reduce market
production of services relative to the
production of other goods (since household
production mainly takes the form of services)
• Hence there is a presumption in favour of a lenient
tax treatment of certain services
AN ALTERNATIVE FRAMEWORK: BECKER
• Consumers get utility from consumption ’activities’
• Consumption activities (’household production’)
require inputs of commodities and time
• Consumers spend time on consumption activities
and on work in the market
• The government must raise a certain amount of
revenue from commodity taxes and cannot directly
tax time spent on consumption activities
THE INVERSE FACTOR SHARE RULE
Kleven (JPubE 2004)
R
tj 
,
1  j
j 
Wn j
Pj a j  Wn j
Implication: The larger the time input required for
consumption, the higher is the optimal tax rate
● The inverse factor share rule preserves the
first-best allocation (in the absence of ’pure’
leisure)
● Implementing the inverse factor share rule only
requires data on consumption and time allocation
PRELIMINARY CONCLUSIONS
ON INDIRECT TAXATION
There are still strong administrative and political
economy arguments for maintaining a high degree
of uniformity in indirect taxation,
but recent contributions to optimal tax theory have
made it easier to identify the
● commodities that are candidates for special tax
treatment
● parameters that determine the optimal indirect
tax structure
Optimal taxation
of capital income
SHOULD CAPITAL INCOME BE TAXED?
ANSWERS FROM OPTIMAL TAX THEORY
• Standard infinite horizon Ramsey
model: No!
• Overlapping generations model:
Generally ’Yes’, except if preferences
are separable in leisure and
consumption
SHOULD THE CAPITAL INCOME TAX
BE UNIFORM?
Suppose a given amount of revenue must
be raised from taxes on capital. The
question then arises:
Should capital income taxes be ’neutral’, i.e.
uniform across different investments?
(Most) economists: Yes!
Politicians: No!
Optimal tax theory: It depends!
THE CASE FOR
’NEUTRAL’ CAPITAL INCOME TAXATION
● Production Efficiency Theorem: Avoid production
distortions when all pure profits can be taxed
away and all household transactions with firms
can be taxed
● We don’t have the information needed to
implement optimal differential capital taxation,
and even if we had, the welfare gain from moving
from neutral to optimal capital taxation would be
small (Auerbach (1989))
● Non-neutral capital income taxation creates
administrative problems and invites lobbyism
A SIMPLE MODEL OF CAPITAL
TAXATION IN THE OPEN ECONOMY
● Two perfectly competitive production sectors
● Three production factors: capital, labor and a fixed
factor (e.g. land)
● Output prices and the required return on capital
given from the world market (small open economy
with perfect capital mobility)
● Labor is immobile across borders but perfectly
mobile between the two domestic sectors
● Fixed total supplies of capital and labor
THE OPTIMAL TAX PROBLEM
Maximize national income
subject to the constraint that
a certain amount of revenue has to be raised
from taxes on capital (which may be
differentiated across sectors)
OPTIMAL RESIDENCE-BASED TAXATION
If the residence principle can be enforced, it is
optimal to levy a uniform capital income tax
on all domestic and foreign investment
Thus neutral capital taxation is desirable when
foreign source income can be taxed
but
the residence principle is hard to enforce
OPTIMAL SOURCE-BASED TAXATION
(Sørensen, ITAX (2007))
Ramsey rule for capital taxation :
   
1
t1
1
t2
2
t1
2
t2
At the margin, the optimal tax policy causes
an equiproportionate reduction of investment
in all sectors
THE COBB-DOUGLAS CASE
• With Cobb-Douglas production functions the
elasticities of capital demand depend solely on
the income shares of labor, capital and land
and on the share of total employment in each
sector
• The optimal relative capital income tax rate
is higher the higher the income share of rents
and the higher the labor income share
Implication: The more capital-intensive sector should
carry a lower relative tax rate, since capital demand is
more sensitive to taxation in this sector
AN INVERSE ELASTICITY RULE FOR
SOURCE-BASED CAPITAL TAXATION
In the special case where only capital is mobile
across sectors (specialized labor), capital
demand in a sector will depend only on the
capital tax rate imposed on that sector
(zero cross-price elasticities)
In that case the optimal capital income tax rate
on a sector is proportional to the inverse of the
elasticity of sectoral capital demand with
respect to the sectoral tax rate
OPTIMAL TAXATION AND CAPITAL FLIGHT
• The elasticity of capital demand stems mainly
from international capital mobility
• A high elasticity of capital demand means that
a higher tax rate will induce a relatively large
capital export
• The Ramsey rule for source-based capital
taxation is therefore consistent with a concern
to avoid too much capital flight (and the desire
to impose relatively low tax rates on particularly
’mobile’ activities)
CAN OPTIMAL DIFFERENTIAL CAPITAL
TAXATION BE IMPLEMENTED?
● If production functions do not deviate too
much from the Cobb-Douglas form, the
elasticities of capital demand may be
deduced from observable variables
(income shares and employment shares)
● Even if the Cobb-Douglas assumption is a
bad approximation, the elasticity of
capital demand is likely to be lower, the
lower the relative importance of capital in
production
Optimal taxation
of labour income
MAKING MIRRLEES OPERATIONAL
● Mirrlees (1971) made a fundamental
contribution to the theory of optimal
taxation, but for many years the theory
remained difficult to apply
● Building on Piketty (1997) and Diamond
(1998), Saez (2001, 2002) derived explicit
optimal tax formulas in terms of labour
supply elasticities and observed properties
of the (wage) income distribution
(key simplification: zero income effects)
A MODEL OF LABOUR SUPPLY
(Saez, QJE, 2002)
● Workers allocate themselves across J
different occupations involving different
levels of effort and income
● By adjusting their effort, workers can move
one step up or down on this income ladder
(intensive labour supply response)
● Workers can decide to participate or to stay
outside the labour market. As net earnings in
an occupation increases, more workers move
from non-employment into this occupation
(extensive labour supply response)
THE OPTIMAL TAX SCHEDULE
IN THE SAEZ MODEL

 jt j 
mi
1 J


h j  1  g j 

1  mi  i hi j i 
1 t j 


mi  marginal tax rate at income level i
t j  'participation tax rate' at income level j
hi  fraction of workers at income level i
g j = social value of one euro distributed to
individuals at income level j

J
i 0
 i = intensive labour supply elasticity
 j  extensive labour supply elasticity

hj g j  1
RESULTS FROM THE SAEZ MODEL
● With zero participation elasticities, the guaranteed
minimum income and the marginal tax rate on
low-income earners are both high
● If participation elasticities are high, net transfers
to the working poor exceed transfers to the nonworking poor and the marginal tax rate on low
earnings is negative (rationale for US type Earned
Income Tax Credit)
Interesting application of the Saez formula: By
solving for gj one can derive the distributional
weights that would make the actual observed tax
schedule optimal (Bourgignon and Spadaro
(2005))
CONCLUSIONS
● The administrative and political economy case for uniform
and neutral taxation remains strong, so deviations from
uniformity and neutrality should be accepted only when
there is a strong efficiency case for doing so
● Recent developments in optimal tax theory have made it
easier to identify the (few) commodities/sectors where
deviations from uniformity and neutrality may be
warranted
● Deviations from uniformity and neutrality occur anyway;
insisting that they must be defensible on optimal tax
grounds may provide a bulwark against ’illegitimate’ nonneutralities
CONCLUSIONS
● When the income elasticity of labour supply
is (close to) zero, the optimal tax schedule
for labour income becomes a relatively
simple function of distributional weights and
a few observable variables
● This optimal tax formula can be ”turned on
its head” and used to derive the
distributional weights that would make the
existing tax policy optimal. This in turn may
help to inform policy-making: Is this really
the distributional pattern that policy makers
want?