Question

1. Why does the optimal tax promote the efficient use of resources? [2. 5 Marks]
2. After the tax is collected, should the money be paid in compensation to those who are harmed by the externality? Explain the pros and cons of compensating those harmed by an externality. [2.5 Marks]

Answer 1

a.) Optimal tax system means designing the tax in such a way so that it maximises the social welfare of the people subject to economic constraints.Social welfare function is basically a utilarian function and hence optimal tax promotes maximising the individual utilities and hence better and efficient use of resources. It promotes people to consume more as optimal tax system reduces the burden from middle class people who are generally salaried and large tax causes distortion.

Hence this system promotes maximum and efficient utilisation of resources.

b.) Tax collected may be used in compensating those who are affected by the externalities because some externalities are very harmful for the economy of any country so in order to stabilise the economy compensation is needed sometimes.

Pros: In case of severe externalities it can cause fatal loss to the economy and hence it stabilises the economy.

Cons: It incurres a huge cost burden on the government and lead to deficit also.

For ex- due to COVID situation many countries all over the world compensated people with many schemes such as waiver of loan interests, free basic facilities such as food , health etc.