Basic Welfare Economics and Optimal Tax Theory

There are two criteria by which economists measure the outcomes of tax policy: 1. E¢ ciency, which is traditionally the purview of economics, and does not involve ethical and normative judgments. E¢ ciency considers only how resources are allocated 2. Equity, which considers the distribution of resources. We will need to refer to social norms and value judgments to get conclusions based on this measure. Economists can trace the implications of speci…c value judgments for social welfare, but economics does not give guidance on which value judgments are the correct ones. Before discussing the e¢ ciency implications of tax systems, we will need to lay out some basic concepts. The terms deadweight loss (DWL) and excess burden are used to describe the burden on individuals in addition to the revenue collected. DWL is a general term that can be used to refer to trade restrictions, market failures, etc., but excess burden is used speci…cally when discussing taxes. Optimal taxation generally refers to tax policies that minimize the DWL of the tax system. However, we may also want to consider what is optimal, or best, from the equity point of view. The goals of both e¢ ciency and equity may not be served by the same tax system. For example, lump sum taxes, which are based purely on endowments and not behavior, are e¢ cient but not equitable. They are optimal from the e¢ ciency standpoint, but not from both. Indi¤erence curves describe the preferences of individuals or households. We generally assume that preferences are given, although this is arguable. Behavioral economics, which is an emerging …eld, speci…cally considers the possibility that preferences may change over time. For example, a procrastinator may prefer not to do something right now, but three days later, would have preferred to complete the task earlier. Such considerations can be very important for public policy issues such as saving for retirement, smoking, and the related tax policy. Forcing people to save more than they prefer makes them worse o¤ if people know and act on their own preferences, but if not, forced saving may be welfare improving. However, we will set aside these possibilities for now and assume that preferences are stable. An indi¤erence curve will describe all of the combinations of apples and oranges that make an individual equally happy. In Figure 1, points A and B make the individual equally happy, but point C is preferred to both. Measures of utility are not unique, although the underlying preferences are. The numbers labeling the utility curves are convenient, but they are meaningless in and of themselves. It is only the underlying ranking of bundles that is uniquely representative of preferences.