ABSTRACT
The theory of taxation and tax reforms has been largely studied in the literature of public finance. To finance its goal of both providing public goods and services and operating changes in the distribution of income generated by the market, the government uses taxes. The positive analysis of taxation has concerned the different taxes that are used by the government, their features, their distribution and their impact on the economic system. The normative analysis has focused on how the government should minimize the “excess burden,” that is, welfare losses from taxation. The literature suggests that this would require taxation to be imposed as a lump-sum, so that taxpayers could not avoid taxation by changes in their behavior. However, since public goods have a different nature than private goods, and due to the limited information of the government, which makes it impossible to identify individual characteristics that taxpayers cannot change to avoid their tax payments, taxes are usually compulsory and not of a lump-sum nature. In this context, the well-known trade-off between efficiency and equity may arise (Fair 1971; Stern 1976; Ahmad and Stern 1984): a tax system is efficient if it minimizes the total excess burden of raising revenues, while this rule turns out to be in contrast with the purpose of redistribution. The more general literature on optimal taxation (OT) (Ramsey 1927; Mirrlees 1971, 1972, 1976) includes redistributive purposes, but at the expense of practicality. The New New Welfare economics, reviewed by Stiglitz (1987), makes clear the nature of these equity-efficiency trade-offs, inherent in redistributive tax policies. The government is assumed to start with imperfect information, as a limit to its ability to impose taxes, and it tries to identify the Pareto efficient tax structures, i.e. the tax structures which get the economies to the utilities possibilities schedule. It turns out that in this “second best” world, a selfselection, or a partial pooling equilibrium, is required for Pareto efficiency, with the marginal tax rate on the highest income individuals being equal to zero. The trade-off derives from the fact that the self-selection constraint generates distortions from redistributing resources from the
more able to the less able individuals, and this distortion is larger if a larger revenue has to be raised.
