Question

8. Discuss why an efficiency-equity tradeoff necessarily exists in constructing an optimal income tax system, when individuals respond taxes by decreasing hours worked and some individuals earn more than others. Explain the roles of the Frisch elasticity of labour supply and the social welfare function.

Answer 1

• An efficiency-equity trade off necessarily exists in constructing an optimal income tax system because it brings a sense of fairness.
• High tax rates reduce economic efficiency.
• Reduce incentive to work.
• Rich has to pay higher taxes depending on income.
• This Trade off concentrates on in efficiency of the tax system and its in equalities.
• It tries to counter them through few measures.

• Roles of Frisch elasticity labour supply measures substitution effect of changing wage rates.
• Provides number of hours worked to the wage rate.
• Taxes in account the dynamic nature of a problem by keeping the marginal utility of wealth constant.

Interpretes wage variations across various individuals.

• The social welfare function ranks the social states as desirables, less desirable or more desirable.
• Individualistic in form.
• Represents prospective patterns of the collective choices.
• Maps individual preference of everyone in society to collective choices.
• Determines the closeness of the analogy to an ordinary utility function.