Optimal Taxation::

Recall that taxes distort the optimal choice of the taxpayers. Commodity taxes in the form of different unit taxes change the price ratio faced by the consumer disturbing thereby the equality between the marginal rate of substitution in consumption and the price ratio as required by the Pareto efficiency. Similarly, income tax changes the post-tax wage rate and as a result, the optimal choice between labour and leisure gets distorted. Therefore, in the process of paying taxes, the taxpayers suffer a loss of welfare. The burden arising out of such tax induced changes are called excess burden (or, deadweight losses), which is over and above loss of income that the taxpayers incur in terms of tax payment. While taxes are unavoidable, the objective of the government should be to minimise the loss of welfare associated with excess burden imposed on the taxpayers subject to a given revenue  requirement while designing a tax system.

Optimal tax theory can be guides for action, i.e., how can one use the theory of optimal taxation to design a tax structure which conforms to the basic tenets of economic theory such as ensuring efficiency and equity in the best possible manner. For example, one can invoke optimal tax theory to address questions such as, how to strike a balance between, direct and indirect taxes, how to determine the degree of progressivity of the direct tax system, or how to choose an appropriate tax base. The theory of  optimal taxation seeks to address this age-old classic question in the theory of taxation, which is relevant for any government dealing with tax policy issues. The question what constitutes a good tax system dates back hundreds of years. Though the  leading economists like Smith, Mill, Edgeworth and Wicksell dealt with some of these issues, it was only during the early 1970s  that these issues were systematically and comprehensively dealt with. One can however recognise an echo of relevant issues in J. Dupuit in the middle of the nineteenth century. As far as formal theorising is concerned, Frank Ramsey (1927) could be considered to be the forerunner. His seminal contribution evoked responses for years to come and paved the way for the development of  literature. Later, Mirrlees (1971) contributed in a big way to the advancement of the literature.

This chapter will give a brief outline of the essential elements of the theory of optimal taxation. Keeping in mind, that the literature is vast and technical in terms of specifications of the various models developed over the years, the approach adopted here is to  stress on the intuition behind the approach and the results derived there from. We begin with a brief recapitulation of some of the basic concepts that you have already studied in earlier units. The basic theory of optimal commodity taxation is introduced which is followed by a discussion of optimal income taxation. We round up the discussion with some issues to understand usefulness of  this theory.