Optimal Tax Theory
March 31, 2009
Overview Description
Optimal tax theory is a study with an aim of finding the best ways to design or plan a tax to avoid inefficiency and economic distortion. The study encompasses such questions as to whether a jurisdiction or government should use commodity tax or income. Additionally, in regard to commodity taxes, how should the tax rates vary across commodities and how should the progressive tax system apply in such a case?
When all variables are constant and equal, and a taxpayer is presented with two options of equally limited economic projects such as investments, which are subjected to the same returns and pre-tax risks, the taxpayer will rationally go with the project with a tax break or a lower tax. In light to this insight, pundits argue that taxes generally distort behavior.
Illustrations of Optimal Tax theory
An applicable example according to economists may be this; individuals on an income tax liability are those actors who engage typically in a market activity of being employed in the ‘actual’ labor market. On the other hand, if one foregoes getting into the ‘actual’ labor market, and instead consume leisure, or work in the house, by say providing the services that could have been provided by a house maid, the tax on such people will be lighter.
Conversely, in an income tax law like that of America where there is the unit of filling income tax jointly as married couples, the taxable income of the worker who opted to provide household services will be placed higher, than the taxable income of the taxpayer who is in the ‘actual’ labor market, and therefore gets the highest marginal rate in this case. Such a tax method creates a large distortion, which will disfavor mostly women from the ‘actual’ labor market.
Another thing that causes distortion is the sales tax imposed on commodities. For instance, food which is prepared in restaurants or eateries is taxed, but the food bought in supermarkets or grocery stores, and prepared at home is not taxed when buying. Therefore, if you as the taxpayer opt to buy food in a restaurant because you are not financially capable of purchasing extra leisure time, (by less working hours), you will indirectly pay more, than a wealthy person who says relish being a home chef and prepares probably the same food at home.
Features of Optimal Tax Theory models
The theory covers a range of models, which focus on the specific aspects of the tax systems mentioned above. All the diverse models have three main features in common.
First, the models specify specific sets of feasible taxes for the jurisdiction and the wants of the government for the revenue. The models characteristically rule out all lump-sum taxes which tend to cause no distortion in the economy.
The second characteristic of optimal tax theory models is that either model spell out how firms and individual taxpayers respond to tax. This means that the firms provide technology and a platform for goods production, individuals have their own preference on goods and leisure, and they end up interacting in a stipulated market structure, more often than not a market ideal for competition.
The final feature of the models encompassed in optimal tax theory is the government’s intention for evaluating varied tax configurations. In the plainest models, the government wishes to minimize excess burden brought about by the tax system, while generating a certain amount of revenue.
That said, optimal tax theory has its own share of criticism from stakeholders citing that the tax generally ignores all the administrative costs of the tax systems. This is because the optimal tax theory stipulates that all goods in an economy are subjected to taxation at varied rates whereby necessities are taxed higher and goods with substitutes are taxed at a much lower rate.
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