Question

5. In general, efficiency will be maximized if all goods and services are taxed at the same rate. Is this true? Discuss.

a. What is the major difficulty with taxing all commodities at the same rate in practice? b. Given that a uniform tax on all goods and services is not possible, a friend suggests taxing all remaining commodities at the same rate, because “that is the next best thing to the most efficient outcome.” Is this suggestion economically valid? Explain by referring to the Theory of the Second Best.

Answer 1

It is false. It is true that administrative cost will fall, compliance will be simple as people have to use only one tax rate as compared to using different tax rates on millions of goods.it also reduces distortion of consumption. It also reduces complexities and political lobbying for lower taxes on certain goods. But there are some problems

First some goods like tobacco, alcohol are harmful for health and need to be taxed more. Since there effect is also cumulative, the rate should be steep. The efficiency loss is greatest when it has largest impact on people's purchasing power. Inverse elasticity rules means goods should be taxed differently. The goods having inelastic demand can be taxed at higher rate. A uniform tax will fall more on poor who have less purchasing power. The essentials need to be taxed at lower rate. In short uniform rate is not practical

As said above the major difficulty is that it falls heavily on poor and also reduces revenue.

No this is not true. According to theory of second best if optimum is not possible, then trying for second best will not maximise welfare.