Gruber3e Ch20 Lecture

Public Finance and Public Policy Jonathan
CopyrightGruber
© 2010Third
WorthEdition
Publishers
Copyright © 2010 Worth Publishers 1 of 30
20.1 Taxation and Economic
Efficiency
Tax Inefficiencies and 20.2 Optimal Commodity
Their Implications for Taxation
20.3 Optimal Income Taxes
Optimal Taxation 20.4 Tax-Benefit Linkages
and the Financing of Social
Insurance Programs
20.5 Conclusion
PREPARED BY
FERNANDO QUIJANO AND SHELLY TEFFT
Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 2 of 30
CHAPTER 20 ■ TAX INEFFICIENCIES AND THEIR IMPLICATIONS FOR OPTIMAL TAXATION
20.1
Taxation and Economic Efficiency
Graphical Approach
20.1
Elasticities Determine Tax Inefficiency
20.1
Elasticities Determine Tax Inefficiency
The inefficiency of any tax is determined by the extent to which consumers
and producers change their behavior to avoid the tax; deadweight loss is
caused by individuals and firms making inefficient consumption and
production choices in order to avoid taxation.
20.1
 APPLICATION
Tax Avoidance in Practice
1. The British boat designer Uffa Fox lived in a home he constructed from a
floating bridge. When the Inland Revenue (Britain’s tax collectors)
attempted to collect property tax on the home, Fox began sailing it up and
down the river. By the time he was done, Fox had collected so many
different addresses that the Inland Revenue gave up their attempts.
2. An Englishman visiting Cyprus in the early 1980s asked a tour guide why
so many of the houses seemed to have steel reinforcement bars jutting out
from their top floors. The guide informed him that Cyprus had a building
tax that applied only to finished structures. Owners of those houses could
thus claim that they were still in the process of finishing the roof.
3. The Thai government levies a tax on signs in front of businesses. The tax is
levied only on external signs and the rate depends on whether the sign is
completely in Thai (low), in Thai and English (medium), or completely in
English (very high). A walk around Bangkok thus reveals many businesses
hanging English signs with a small amount of Thai writing in the upper-
right-hand corner. Some businesses manage to avoid the tax entirely by
printing the message on curtains that are hung in the front window,
rendering the sign “internal” and thus tax-exempt. 
20.1
Determinants of Deadweight Loss
The formula for DWL is
1 s d Q
DWL    
2
2( s   d ) P
where  d is the elasticity of demand,

 s is the elasticity of supply,
and  is the tax rate.
marginal deadweight loss

The increase in deadweight
loss per unit increase in the tax.
20.1
Determinants of Deadweight Loss
20.1
Deadweight Loss and the Design of Efficient Tax Systems
A Tax System’s Efficiency Is Affected by a Market’s
Preexisting Distortions
preexisting distortions Market failures, such

as externalities or imperfect competition, that are
in place before any government intervention.
20.1
A Tax System’s Efficiency Is Affected by a Market’s
Preexisting Distortions
20.1
Progressive Tax Systems Can Be Less Efficient
20.1
Progressive Tax Systems Can Be Less Efficient
Why is the deadweight loss larger for the higher-wage worker

despite the same reduction in hours worked? Because in a competitive labor
market, the wage rate equals the marginal product of labor, so the high-
wage worker has a higher marginal product of labor. As a result, society
loses more efficiency when the high-wage worker reduces her hours (at a
marginal product of $20 per hour) than when the low-wage worker reduces
her hours (at a marginal product of $10 per hour).
The guiding principle for efficient taxation is to create a broad and level
playing field rather than taxing some groups or goods particularly highly
and others not at all.
20.1
Governments Should “Smooth” Tax Rates Over Time
Just as individual utility is maximized by full consumption smoothing,
government efficiency in taxation over time is maximized by tax
smoothing, by having a relatively constant tax rate over time rather than
high taxes in some periods and low taxes in others.
20.1
 APPLICATION
The Deadweight Loss of Taxing Wireless Communications
Hausman (2000) estimated the deadweight loss from a particularly dynamic
sector of our economy: wireless communications services:
• In 1999, the state and federal tax burden on wireless communication in the
typical state was 14.5%, although the rate was 25% in high-tax states.
• Hausman estimated that for every dollar the government raised in taxes,
social welfare was reduced by 53¢.
This figure is high for three reasons:
• Demand for wireless communications is fairly price sensitive.
• There is already a large preexisting distortion in this market.
• The taxes are fairly high, and the marginal deadweight loss rises with the
tax rate.
Hausman estimated that the marginal deadweight loss caused by an additional
tax on wireless services ranged from 72¢ to 90¢ per dollar raised. 
20.2
Optimal Commodity Taxation
Ramsey Taxation: The Theory of Optimal Commodity Taxation
optimal commodity taxation Choosing the tax rates

across goods to minimize deadweight loss for a given
government revenue requirement.
Ramsey Rule To minimize the deadweight loss of a

tax system while raising a fixed amount of revenue,
taxes should be set across commodities so that the
ratio of the marginal deadweight loss to marginal
revenue raised is equal across commodities.
value of additional government revenues The value

of having another dollar in the government’s hands
relative to its next best use in the private sector.
20.2
Inverse Elasticity Rule
If we assume that the supply side of commodity markets is perfectly
competitive (elasticity of supply is infinite), then the Ramsey result implies
that

where  i is the optimal tax rate for commodity i, and iis the elasticity of demand for commodity i.
This formulation of Ramsey’s rule shows that two factors must be

balanced when setting optimal commodity taxes:
 The elasticity rule: When elasticity of demand for a good is high, it

should be taxed at a low rate; when elasticity is low, the tax rate
should be high.
 The broad base rule: It is better to tax a wide variety of goods at a

moderate rate than to tax very few goods at a high rate. Because the
marginal deadweight loss from a tax rises with the tax rate, the
government should spread taxes across a large number of commodities
and not tax any one commodity at a very high rate.
20.2
Equity Implications of the Ramsey Model
Imagine that the government had only two goods it could tax, cereal and
caviar:
• The elasticity of demand for caviar is much higher than that for
cereal, so the inverse elasticity rule would suggest that the
government tax cereal much more highly than caviar.
• This would mean imposing a tax on a good consumed exclusively by

higher-income groups that was much lower than the tax imposed on a
good consumed by all.
This outcome, while efficient, might violate a government’s sense of tax

fairness across income groups (vertical equity).
20.2
 APPLICATION
Price Reform in Pakistan
Angus Deaton (1997) studied the demands for commodities in several
developing nations. He used variation in prices encountered by consumers of
rice, wheat, and other commodities to estimate their elasticities of demand.
20.2
Efficiency Consequences
of Subsidies and Taxes in
Pakistan • In panel (a), the
market for wheat, demand is
fairly inelastic and supply is
subsidized, leading quantity
to increase from Q1 to Q2 with
a deadweight loss of BAC. In
panel (b), the market for rice,
demand is very elastic, so
when supply is subsidized the
quantity rises by much more
(from Q1 to Q2), and the
deadweight loss is larger
(BAC). In panel (c), the
market for oils and fats,
demand is also very elastic,
so even the small tax leads to
a large reduction in quantity
from Q1 to Q2, with a
deadweight loss of BAC.
Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers

19 of 30
20.3
Optimal Income Taxes
optimal income taxation Choosing

the tax rates across income groups to
maximize social welfare subject to a
government revenue requirement.
20.3
A Simple Example
It is helpful to begin with a simple example that makes the following
assumptions:
1. Everyone in society has the same utility functions (U1 = U2 = . . .).
2. These utility functions exhibit diminishing MU of income.
3. The total amount of income in society is fixed (so incomes are not
determined by individual choices that might respond to tax rates).
4. Society has a utilitarian social welfare function (V = U1 + U2 + . . .)
under which each individual’s utility is weighted equally in determining
social welfare.
Under these assumptions, the optimal income tax system is one that leaves
everyone with the same level of post-tax income.
Any individuals with incomes below this level would receive a transfer from
the government that would increase their incomes to the average amount.
With this system, each additional dollar of earnings either reduces one’s
transfer by $1 (if below the average income level) or raises one’s tax by $1
(if above the average income level).
20.3
General Model with Behavioral Effects
20.3
General Model with Behavioral Effects
The optimal income tax system meets the following condition:
set income tax rates across groups such that MU i MRi  

Where MU is the marginal utility of individual i,
MR is the marginal revenue raised from taxing that individual,
and 
is the value of additional government revenues.
In the case of income taxation, the optimal tax system reflects a different
balancing:
 Vertical Equity: Social welfare is maximized when those who have a
high level of consumption, and thus a low marginal utility, are taxed
more heavily, and those who have a low level of consumption, and thus
a high marginal utility, are taxed less heavily.
 Behavioral Responses: As taxes rise on any one group, individuals in
that group may respond by earning less income.
20.3
An Example
20.4
Tax-Benefit Linkages and the Financing of Social
Insurance Programs
tax-benefit linkages Direct ties between

taxes paid and benefits received.
20.4
Insurance Programs
The Model
20.4
Insurance Programs
Issues Raised by Tax-Benefit Linkage Analysis
If There Is No Inefficiency to Providing a Benefit, Why
Doesn’t the Employer Just Do So Without
Government Involvement?
20.4
Insurance Programs
Issues Raised by Tax-Benefit Linkage Analysis
When Are There Tax-Benefit Linkages?
The tax-benefit linkage is strongest when taxes paid are linked directly
to a benefit for workers.
What Is the Empirical Evidence on Tax-Benefit Linkages?
The existing literature suggests that the cost of social insurance
financing is borne by workers in the form of lower wages and not lower
employment.
20.4
Insurance Programs
EM P I R I C A L E V I D E N C E
A GROUP-SPECIFIC EMPLOYER MANDATE
Gruber (1994) examined the impact on wages and labor supply of a group-
specific mandated benefit.
Before the mid-1970s, health insurance plans provided very little coverage for
the costs associated with normal pregnancy and childbirth. This was viewed as
discriminatory by some state governments, leading to the state laws mandating
that pregnancy costs be covered as completely as other medical costs.
These laws significantly increased the insurance costs for women of
childbearing age in those states, thereby raising the costs of employing a
specific group of workers (treatment group). There were two possible control
groups: similar workers in other states that did not pass these laws, or other
groups of workers within the states that did pass these laws.
Gruber’s study compared the changes in wages and labor supply of the
treatment group around the time of the passage of these laws to the changes in
both of these control groups.
The results show that the cost of this new mandate was fully passed on to the
wages of the affected groups, with little effect on their labor supply.
20.5
Conclusion
The fundamental issue in designing tax policy is the equity-efficiency trade-

off.
Understanding tax efficiency really comes down to remembering two key

principles:
• The more elastically supplied or demanded the good, the larger the
deadweight loss from the tax.
• The higher the tax rate, the larger the incremental deadweight loss of
taxation.
Trading off these two considerations is the key to understanding the

efficiency aspects of the tax policies.

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Public Finance and Public Policy Jonathan

FERNANDO QUIJANO AND SHELLY TEFFT

The formula for DWL is

where  d is the elasticity of demand,

marginal deadweight loss

preexisting distortions Market failures, such

Why is the deadweight loss larger for the higher-wage worker

optimal commodity taxation Choosing the tax rates

Ramsey Rule To minimize the deadweight loss of a

value of additional government revenues The value

This formulation of Ramsey’s rule shows that two factors must be

 The elasticity rule: When elasticity of demand for a good is high, it

 The broad base rule: It is better to tax a wide variety of goods at a

• This would mean imposing a tax on a good consumed exclusively by

This outcome, while efficient, might violate a government’s sense of tax

optimal income taxation Choosing

set income tax rates across groups such that MU i MRi  

tax-benefit linkages Direct ties between

The fundamental issue in designing tax policy is the equity-efficiency trade-

Understanding tax efficiency really comes down to remembering two key

Trading off these two considerations is the key to understanding the

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