Optimal Taxation

Abstract

Theories of optimal taxation involve formal descriptions of some of the classic and unavoidable questions of public finance: the balance between indirect and direct taxation; the progressivity of the income tax; whether income or expenditure is the appropriate basis for taxation; the desirability or otherwise of differentiated proportional commodity taxes and so on. At the heart of many of these questions is a trade-off between equity and efficiency, an issue which is very familiar. Further, many of the problems have been discussed by leading economists at least since Adam Smith and including Mill, Edgeworth and Wicksell. It is striking, therefore, that whilst there were some isolated important contributions we had to wait until the early 1970s to see an intensive and direct analysis of the underlying problems. The literature has now reached the point where, in addition to the many formal results, one can distil some intuitive lessons which provide useful ways of thinking about tax questions, basic principles, and some warnings of misleading arguments. In this brief description of optimal tax theory we shall try to draw out some of these lessons as well as providing an introduction to the formal models and analyses.

This chapter was originally published in The New Palgrave: A Dictionary of Economics, 1st edition, 1987. Edited by John Eatwell, Murray Milgate and Peter Newman