Question

Consider a government that imposes a personal income tax. It is estimated that the tax will not affect total labour supplied in the economy. Given this, the political party advocating for the tax argue that the tax acts as a non-distortionary, lump-sum tax, and as such imposes no excess burden. Is this a reasonable argument?

Answer 1

Optimal tax theory or the theory of optimal taxation is the study of designing and implementing a tax that maximises a social welfare function subject to economic constraints.^[1] The social welfare function used is typically a function of individuals' utilities, most commonly some form of utilitarian function, so the tax system is chosen to maximise the aggregate of individual utilities. Tax revenue is required to fund the provision of public goods and other government services, as well as for redistribution from rich to poor individuals. However, most taxes distort individual behavior, because the activity that is taxed becomes relatively less desirable; for instance, taxes on labour income reduce the incentive to work.^[2] The optimization probleminvolves minimizing the distortions caused by taxation, while achieving desired levels of redistribution and revenue.^[3][4] Some taxes are thought to be less distorting, such as lump-sum taxes (where individuals cannot change their behaviour to reduce their tax burden) and Pigouvian taxes, where the market consumption of a good is inefficient and a tax brings consumption closer to the efficient level.^[5]

In the Wealth of Nations, Adam Smith observed that

“Good taxes meet four major criteria. They are (1) proportionate to incomes or abilities to pay (2) certain rather than arbitrary (3) payable at times and in ways convenient to the taxpayers and (4) cheap to administer and collect.”  ^[6]

The theory of optimal income tax on individual labor aims to find the optimal trade-off between the following three effects of increasing taxation:

• The mechanical effect - an increase in tax-rate increases the government revenue, if no individuals changed their behaviour in response.
• The behavioural effect - an increase in tax-rate discourages labour supply, and this leads to lower tax revenue as a result.
• The welfare effect - an increase in tax-rate reduces the individual utility, and thus reduces social welfare.