Abstract
Results in the theoretical literature on optimal taxation are reviewed to study their relevance for the design of income and commodity tax reforms in India. Given the recent steep increase in inequality, there is a need to increase significantly the overall progressiveness of the Indian tax structure. In the absence of a comprehensive income tax base in India, where much of income escapes taxation, this can be done by greater reliance on commodity taxation. GST slabs and GST rates have to be fixed in accordance with the “many-person Ramsey rule” for commodity taxation that is based on both equity and efficiency considerations. Currently, there is not much variation in the marginal income tax rates faced by people at the high end of the income distribution, even though there is a lot of variation in their incomes. This implies that the existing income tax design gives nearly the same social welfare weights to both billionaires and salaried people with incomes close to Rs. 10,00,000. Thus, to combat the growing inequality in India, the progressiveness of income taxation at the tail of the income distribution also needs to be significantly increased, as this will be equivalent to making social preferences more inequality-averse.
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Notes
The many person Ramsey rule is the characterisation of the optimal commodity tax structure, which is based on both equity and efficiency considerations. See Sect. 3.2.1.
Assuming a constant elasticity of labour supply.
The conditions include (1) consumption efficiency—equalisation of the marginal rates of substitution between goods in consumption across all consumers, (2) production efficiency—equalisation of the marginal rates of substitution between goods in production across all producers, and (3) joint consumption and production efficiency— equalisation of the marginal rates of substitution between goods in consumption and production.
In particular, in a partial equilibrium framework with one taxable good and an untaxed numeraire good, the imposition of a positive commodity tax to raise a given amount of governmental revenue simultaneously raises the consumer price and reduces the producer price, thereby restricting the demand and supply of the commodity below its socially optimal level. Under a lump-sum tax, however, the commodity continues to be produced at its socially optimal level. Tax is paid entirely out of the endowment of the numeraire commodity. [Recall that partial equilibrium analyses are conducted employing a quasi-linear preference structure, where the good under study is not subject to income effects. See, e.g. Mas-Colell et al. (1995)].
We will relax the assumption of a single aggregated firm in Sect. 3.2.2.
If the net demand of a good by a consumer is negative, then this is a positive supply of the good to the firm by the consumer. If the net supply of a good by the firm is negative, then it is a positive net input demand for the good by the firm. Under constant returns to scale, the supplies of goods in equilibrium are entirely determined by the aggregate consumer demands.
See for example, Guesnerie (1995).
See also Mirrlees (1976).
\(\varepsilon ^h_k=\frac{\partial e^h_k}{q_k}\frac{q_k}{e^h_k}\) is the elasticity of compensated demand for good k with respect to its own price \(q_k\) for consumer h.
This provided a powerful counterexample to the very influential claim by Lipsey and Lancaster (1956) that in the presence of a distortion in the economy, which makes attainability of at least one of the first-best Pareto optimal conditions impossible, the remaining Pareto optimal conditions, although still possibly attainable, are no longer desirable at a second-best optimum.
For example, if there were only two goods, with one good being the input, say labour, and the other good being a standard consumption good like apples, then the relevant production marginal rate of substitution is the marginal product of labour. In that case, production efficiency is true if individual firms produce at frontier points of their individual technologies where their marginal products of labour are the same. The aggregate production will then lie on the frontier of the aggregate technology.
For example, at a profit maximising production bundle, marginal rates of technical substitution between inputs are equal to the input price ratios, marginal rates of product transformation between two outputs are equal to the output price ratios, and the marginal product of an input in the production of an output is equal to the ratio of the input and the output price.
See also Myles (1995).
The first equality is the definition of \(\lambda _i\), while the second equality is derived from computing the numerator and denominator of \(-\frac{\partial W}{\partial t_i}\big /\frac{\partial R}{\partial t_i}\).
If the tax schedule is kinked, then the consumption schedule is also kinked. It is possible that, in such a situation, consumers of multiple ability types choose the same optimal consumption bundle. This phenomenon is called bunching in the income tax literature.
Utility maximising bundles \(\left\langle c(n), y(n)\right\rangle\) and \(\left\langle c(n'), y(n')\right\rangle\) for consumers of abilities n and \(n'\) are both points in the budget set (6), but since consumer of ability n chooses the former when the latter is also available, it must be the case that
$$\begin{aligned} U\left( c(n), y(n),n\right) \ge U\left( c(n'), y(n'),n\right) ,\ \forall \ n,n'. \end{aligned}$$A special case of this social welfare function is the utilitarian social welfare function \(W=\int _0^{\infty } u(n) f(n) {\text {d}}n\), where social welfare is sum of individual utilities.
For more general preference structures, see Saez (2001).
Intuitively, their number is given by the density h(y).
See Crawford et al. (2010).
See https://stats.oecd.org, Comparative Tables of the OECD Revenue Statistics.
Both as percentage of GDP
Mukherjee (2017) estimates tax capacities and tax efforts of Indian states.
Progressiveness of a tax structure measures the rate at which the average tax rate or the tax burden (the share of tax in total income) increases with increase in income. If the average tax rate (ATR) increases with increase in income, then the tax system is progressive. If it decreases (respectively, stays constant), then the tax system is regressive (respectively, proportional).
Recall that, empirically, the hazard rate takes a constant value after a certain level of income.
This is assuming that the disincentive effects of high rates of taxation are small or not too significantly different at high levels of income. Or, even when there is a variation in the elasticity of the earnings of the people with respect to marginal tax rate, it is possible that, analogous to examples given for commodity taxes, equity considerations can offset loss in welfare due to the disincentive effects of higher marginal tax rates. This remains to be verified by further empirical work in this area in the Indian context.
See Sect. 5.
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Murty, S. Some results from the theory of optimal taxation and their relevance for increasing the progressiveness of Indian tax structure. Ind. Econ. Rev. 54, 19–50 (2019). https://doi.org/10.1007/s41775-019-00048-3
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DOI: https://doi.org/10.1007/s41775-019-00048-3
Keywords
- Commodity taxes
- Income taxes
- Many person Ramsey rule
- Equity-efficiency trade-offs
- Marginal tax rates
- Progressiveness of tax structure