Question

Why is it important to consider the economic efficiency of taxes in addition to the distribution of tax burdens?

• Why is it the case that the DWL of taxation grows with increases in the elasticity of demand or supply?

• What are the implications of the fact that the marginal DWL of taxation increases with the tax rate?

• What is the Ramsey rule? What does it tell us about what goods should be taxed at a relatively high rate from an efficiency standpoint?

• How do behavioral effects complicate the design of an income tax system, and particularly a progressive income tax system?

Answer 1

Why is it important to consider the economic efficiency of taxes in addition to the distribution of tax burdens?

Economic efficiency is achieved when firm operates at the minimum level of average cost. But increase in tax would reduce the output level which implies that now firm may not be operating at minimum level of AC. Hence, this aspect is also considered while mulling over the taxes.

• Why is it the case that the DWL of taxation grows with increases in the elasticity of demand or supply?

Deadweight loss is caused by the fall in output and rise price level. If demand or supply happens to be more elastic, then rise in tax would significantly change the quantity supplied or demanded. Hence, size of deadweight loss increases significantly as well.

• What are the implications of the fact that the marginal DWL of taxation increases with the tax rate?

It will increase inefficiency in production system.

• What is the Ramsey rule? What does it tell us about what goods should be taxed at a relatively high rate from an efficiency standpoint?

Ramsey rule refers to rule that is followed while deciding monopoly price to maximize public welfare. Both profits of monopoly and public welfare are protected.

There should be inverse relationship between tax and elasticity. Goods with low elasticity should be taxed at higher rate.