Chapter

9 Tax Structure for Efficiency and Supply-Side Economics in Developing Countries

Author(s):
Ved Gandhi, Liam Ebrill, Parthasarathi Shome, Luis Manas Anton, Jitendra Modi, Fernando Sanchez-Ugarte, and George Mackenzie
Published Date:
June 1987
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Author(s)
Ved P. Gandhi

Supply-side economists stress minimizing the distortions that taxes, in general, and high and progressive taxes, in particular, inject into market decisions and believe that reforming the tax structures, in general, and lowering the rates of taxes, in particular, would encourage savings and production by allowing the economic incentives of a free market to work.1 As the problems of developing countries frequently are the result of insufficient savings and production, it would appear, prima facie, that the tax policy prescriptions of supply-siders, viz., low and less progressive taxes, could be highly relevant to them. This argument provides the background for the present paper.

The purpose of this paper is not to discuss the validity of factor and output elasticity (growth) optimism of the popular supply-side economists; this has been examined in the preceding chapters and by other authors.2 Instead, this paper attempts to identify the relationships that the tax policy prescriptions of supply-side economics bear with those of the traditional and modern literature on taxation. In addition, it seeks to establish what the tax system of developing countries would look like if supply-side (disincentive) effects of taxation and efficiency in the allocation of resources were the major concerns of tax policymakers. The discussion in the chapter covers both tax design (establishing a new tax system) and tax reform (revising the existing tax system).

This chapter therefore has five objectives. First, it defines the efficiency objective of a tax system, reviews the importance of this objective among multiple objectives of taxation in the literature, and describes the broad theoretical characteristics of a tax system based on efficiency considerations (Section I). Second, after reviewing selected literature on taxation, it attempts to throw light on those elements of a tax structure, or the structure of tax bases, that would minimize distortions and thus would be consistent with the efficiency objective (Section II). Third, it seeks to define a rate design, or the structure of tax rates (including its progressivity), that would be least distortionary and thus would be consistent with the efficiency objective (Section III). Fourth, it examines the differences between a popular supply-side economist and a modern optimal tax economist (Section IV). Finally, the chapter concludes with some thoughts on the implications of the popular supply-side approach to tax reform in developing countries.

I. Supply-Side Objectives of the Tax System—in Theory

Supply-side economists stress that “neutrality” in taxation is the most desirable of all objectives of taxation, but, if for some practical reason this objective is unattainable, a second-best aim should be to minimize the distortionary substitution and excise effects of taxation. In fact, as was mentioned in Chapter 1, few tax economists would disagree with the importance attached to the neutrality objective or the reduction of distortionary effects of taxation.3 In theoretical literature, this objective is labeled as the “efficiency” objective of taxation.4 In this paper, therefore, the two terms, neutrality and efficiency, will be used interchangeably.

Conflicts Among Multiple Objectives of Taxation

Traditional tax theory, taking a cue from political reality, considered taxation as an instrument with multiple objectives: to raise adequate revenue with administrative ease, to correct externalities and play a sumptuary role, to redistribute income and wealth and, since Keynes, to stabilize aggregate demand and support other macroeconomic objectives. As the history of economic thought reveals, it is not that the traditional tax literature ignored the supply-side effects (distortionary economic effects) of taxation that so concern supply-side economists, but that it frequently treated efficiency and equity as two separate criteria. The traditional tax literature discussed them sequentially offering little or no guidance on how they could or should be combined.5 When the two conflicted, the traditional theory tended to allow the objective of equity and fairness in taxation take precedence over neutrality and efficiency.

For example, while Adam Smith’s famous canons of taxation (equity, certainty, convenience, and collection cost) did not include a supply-side objective and he ultimately argued in favor of the ability-to-pay principle (“The subjects of every state … ought to contribute … as nearly as possible, in proportion to their respective abilities”), he was, nevertheless, well aware of the effects of high taxes on output and government revenues via the behavior of taxpayers. As he wrote, “high taxes, sometimes by diminishing the consumption of the taxed commodities and sometimes by encouraging smuggling, afford a smaller revenue to government than what might be drawn from more moderate taxes.”6

Alfred Marshall did not have much to say on the objectives of a good tax system, yet he argued that high excise taxes on necessities were better than many other taxes because, given their low elasticity of demand, they have the least effect on consumer welfare: “If therefore a given aggregate taxation has to be levied ruthlessly from any class it will cause less loss of consumers’ surplus if levied on necessaries than if levied on comforts.”7

Arthur Pigou considered a tax system based on the principle of least aggregate sacrifice (i.e., on distributional considerations) to be ideal, but he, too, was very conscious of the “announcement effects” of high tax rates on the supply of work effort, savings, and risk-undertaking. He was particularly concerned about the significance of these effects on savings.8

Henry Simons had all the attributes of becoming the first supply-side tax economist. A strong advocate of reducing the role of government, he disliked selective consumption taxes because they interfered with the free private allocation of resources. He also disliked general consumption taxes because they were easy to collect and were likely to lead to irresponsible government expenditure. Nonetheless, he, too, ended up favoring progressive taxation, essentially on the “moral” ground of reducing inequality. He was, of course, quite concerned about the economic effects of progression on the supply of capital, but accepted the trade-off between equity and growth, finally asserting that the dangers of infringement of taxes on incentives were much exaggerated.9

It must, therefore, be recognized that tax policy has been and will remain an instrument of achieving multiple objectives. Many leading traditional theorists on public finance have struggled with the multiplicity of objectives of taxation but, while recognizing the likely economic (relative price) effects of taxation, concluded that equity was the more important objective in designing a tax system.10 Once that was accepted, the traditional literature on taxation concentrated on the search for a proper tax base (i.e., the measures of ability to pay—income, expenditure, wealth) and a proper rate structure (i.e., the measures of equality of sacrifice—progressivity, proportionality, regressivity).11

A Neutral Tax System

The relevant question that this chapter must address is the following. If the multiple objectives of taxation are to be foresaken and if neutrality or efficiency is to be the paramount objective of taxation (i.e., if the primary aim is to cause minimal distortions to the choices of economic agents), what is an ideal tax system? A clue to the answer to this question is provided by the theory of the first-best and the second-best taxation, succinctly developed primarily in the recent literature on optimal taxation.

General Theory of the First-Best Taxation

The theory of first best claims that, in the absence of market failures,12 all taxes, except lump-sum taxes and those levied on inelastic bases that an individual cannot alter by any of his actions, should be considered distortionary.13 All taxes, other than those mentioned above, increase rather than reduce distortions in one or more of the following: (1) the relative prices of commodities; (2) the relative rewards of factors of production; (3) the relative values of present versus future consumption; and (4) the relative rewards of work versus leisure.

Government activities should, therefore, as a first-best solution, be primarily financed not through taxes (except via a poll tax or a tax on inelastic bases which alone are consistent with Pareto optimum), but through user prices.14

This view of taxation depends on five main assumptions. (1) Choices made by individuals are better than other choice mechanisms, since all individuals are rational economic beings and have the relevant information needed for making rational decisions. (2) Product and factor markets are perfectly competitive, factors are perfectly mobile, and pretax market prices reflect true social opportunity costs. Implicit in this assumption is the belief that the cost of and benefits from consumption or production are wholly internalized—there are no externalities or spillovers. (3) Individual behavior is affected by prices (taxes being, of course, elements of prices); that is, there are neither social and institutional constraints nor any uncertainty influencing individual economic behavior. (4) Government expenditures have no desirable effect on relative prices; they certainly cannot compensate for the distortionary effects of taxation on relative prices and at the same time provide “merit goods” that may be desirable on social welfare grounds. (5) Redistribution is not a major objective of taxation; the initial distribution of income and wealth as well as the redistribution generated by market forces (and lump-sum transfers, if any) are correct and socially acceptable or else that redistribution should be achieved by policy instruments other than taxation.

The theory of first best does tolerate some taxation (and subsidies) besides poll taxes, even though it affects market-determined relative prices, but only under two conditions. The first condition is that it correct some major market failure (such as positive and negative externalities), that is, raise the level of private costs to the level of social costs or absorb the excess of private benefits over social benefits.15 This, of course, requires that there is an agreement among one and all as to the existence and magnitudes of externalities in the economic system and that the differences between private and social costs (and benefits) can be measured to design an optimal tax (or subsidy). The second condition is that the negative tax or the subsidy bring the prices charged by decreasing-cost (i.e., increasing-return) industries to the level of long-run marginal costs and optimize output.

General Theory of the Second-Best Taxation

The theory of second best starts with the premise that (1) reality is unlikely to conform to the assumptions needed for first-best solutions; (2) lump-sum taxes are generally infeasible, forbidden, or simply insufficient to meet revenue needs; and (3) all other taxes distort individual choices and create deadweight (welfare) losses to the consumer and/or to the producer, by placing a “wedge” between prices paid and prices received.

The basic premise of the theory of the second best, then, is that when a government must raise a given amount of revenue by imposing a distortionary tax (i.e., a tax with “excess” burden), it is generally optimal to tax all goods and factors at differentiated rates to bring about equiproportional changes in compensated demand and supplies so as to minimize excess burden (Ramsey rule).16 That is, tax rates should not be uniform: goods and factors with relatively inelastic demand and supply should be subjected to relatively higher rates of taxation. This is the well-known inverse elasticity rule, according to which an efficient tax is one whose rate is proportional to the inverse of the price elasticity of the tax base.

The recent optimal taxation literature, which deals with direct versus indirect taxes, as well as the mix between direct and indirect taxes, is essentially an application of this theory of the second best and attempts to minimize the deadweight loss of any and all packages of distortionary but feasible taxes.17 The design of a tax system in the second-best situation requires that, for each individual, the own- and cross-price elasticities of demand (of commodities consumed) and supply (of factor inputs) are known and that, despite the wide range of elasticities that exist between individuals, it is possible to “personalize” the tax base and the tax rates for each individual separately.

Conclusion

In sum, a tax system would seem to meet the efficiency or supply-side objective fully if it either did not affect relative prices at all (theory of first best), or if it only affected them in a unique manner, as described above (theory of second best). The tax-mix and the rate-design characterizing such a tax system, which emerge from the foregoing discussion, is summarized in Table 1.

Table 1.Characteristics of a Tax System Consistent with Efficiency and Supply-Side Economics
Objective(s)Tax Base(s)Tax Rate(s)
1.No effect on relative prices.User prices for most public services and a lump-sum tax and/or a tax on completely inelastic base to finance pure public goods.User prices as determined by the equilibrium of demand and supply for public services and any rate of lump-sum tax as well as tax on completely inelastic base.
2.Affect relative market prices but only to correct market failures and externalities.Taxes on negative production and consumption externalities.A rate of tax which will capture the degree of externality.
3.Least distortion of choices of economic agents.Taxes on items of relatively inelastic (or less elastic) demand and relatively inelastic (or less elastic) supply of both commodities and factors of production.Tax rate inversely related lo elasticity of demand and positively related to elasticity of supply.

As is apparent from Table 1, a neutral and efficiency-dictated tax system would require reforms in the tax bases as well as in the tax rates. As a matter of fact, only a certain mix of taxes and a mix of (upward and downward) revisions in the rates of taxes would be consistent with efficiency-oriented tax reforms. The next two sections deal with the ingredients of a supply-side or efficiency-based tax system more fully.

II. Tax Bases for Supply-Side Economics or Efficient Tax Bases

A review of selected traditional and modern literature on taxation shows that there is agreement as to the bases that should be taxed if allocative efficiency was the only consideration of policymakers. Those taxes that either have no effect on relative prices or have no substitution effects would be considered most desirable. The next in line would be those taxes that have least distortionary effects on relative prices.

Appropriate Taxes for Efficiency Objective

A tax system geared toward efficiency or supply-side objective alone would consist of the following taxes:

  • taxes for internalizing the negative externalities;

  • poll tax;

  • taxes on land area;

  • taxes on windfall or monopoly profits;

  • taxes on items with inelastic demand (such as basic necessities); and

  • taxes on the ability of individuals to earn income, or on potential income. (The second-best alternatives to this proposal would be either a tax on accrued income of an individual coupled with taxes on the consumption of complements to leisure, or a tax on life-time personal expenditures.)

The rationale for taxes for internalizing the externalities and the poll tax is clear from the arguments given in Section I.18 Taxes on land area are defensible on the assumption that land is in inelastic supply, so that the ground rent of land is a sort of economic rent. Taxes on windfall or monopoly profits are justified on the ground that they will not affect price and production decisions made by producers before the imposition of such taxes. Taxes on basic necessities are defended on the ground that these commodities tend to have inelastic demand.

A tax on ability to earn income or on potential income is also acceptable but this requires further explanation. Whereas a tax on actual earnings allows a person to favor leisure over work, a tax on potential income as determined by ability (which is inelastic in supply) is said to be nondistortionary.19 However, ability is difficult to measure, so that a tax on potential income will be difficult to administer. Hence a tax on accrued income (including own consumption, transfers by gifts and bequests, and unrealized capital gains), though a poor second best, is considered a vast improvement over existing income tax systems, which are based on realized money incomes and which contain many tax shelters and loopholes. But a tax on accrued income, besides entailing the well-known problem of how to measure the unrealized gains, would still suffer from intratemporal and intertemporal inefficiencies: the leisure component of welfare or economic capacity would still remain tax free, resulting in intratemporal welfare loss from distortions in work-leisure choices, and savings would continue to be penalized by double taxation causing intertemporal inefficiency. (The latter would be exacerbated by inflation.)

To avoid the distorting effect of income taxes on intratemporal choices, and recognizing the difficulties of taxing leisure, taxes on consumption goods that are complements to leisure are generally recommended. To avoid the distorting effect of income taxes on intertemporal choices, the exemption of savings from the tax base is favored and the levy of a flat-rate tax on the lifetime consumption of an individual (with a personal exemption or an exemption that recognizes differences in family circumstances) is considered theoretically attractive. Leisure will, nonetheless, remain untaxed even under a personal consumption or expenditure tax, producing a disincentive to work; consequently, even the proposal to replace an income tax by a personal consumption tax will not be completely satisfactory on efficiency grounds. However, the efficiency losses of an expenditure tax are stated to be much smaller than those of the present income tax, which is frequently based on realized incomes and a nonindexed tax base, and which arbitrarily discriminates among various forms of savings (e.g., in favor of owner-occupied housing and against equity investment).20

Efficiency or supply-side considerations would thus demand that many taxes existing in the tax systems of developing and developed countries should be eliminated.21 There is no place, for example, in such a system for the following:

  • A separate corporation income tax—for without imputation (adequate credit to the shareholder), it is an additional tax on the form of business organization, and all incomes and taxes must, in the final analysis, be imputed to individuals. In addition, a corporation income tax also tends to be nonneutral whenever (1) tax depreciation differs from economic depreciation; (2) inventory valuation in inflationary times is different from that on replacement basis (last in, first out rather than first in, first out); and (3) dividends are treated differently from interest payments. The tax can become neutral provided these differences are eliminated or the tax allows “free depreciation” and is based on cash flow rather than on profits.

  • Tax loopholes, special tax preferences, or tax incentives—for they affect relative taxes and prices. (Although some of these may be defended on the grounds that they accommodate market failures, an expenditure subsidy rather than a tax expenditure is the proper vehicle for meeting this objective.)

  • A wealth tax—for in the final analysis this is only an additional tax on savings and capital accumulation.

  • Gifts and transfer taxes—for a tax on accrued incomes would theoretically cover all receipts from gifts and transfers.

  • A general sales tax—for this tends to affect consumer choices, especially as all goods and services with very different elasticities of demand and supply tend to be taxed relatively uniformly.

  • A payroll tax—for it is an arbitrary additional tax on wage incomes.

  • A separate capital gains tax—for capital gains are theoretically included in accrued income.

In the specific circumstances of developing countries, an efficiency-based tax system would require, in addition, the elimination of both export duties (unless they are seen as taxes on windfalls only, not affecting incentives, as shown in Chapter 11) and import duties (unless they are seen as protecting domestic industry only temporarily during which the externalities resulting therefrom can be internalized).

There will also be no case for other narrowly based taxes, such as an urban property tax or a rural land tax, which affect relative sectoral prices.

How Realistic Is Such a Tax System?

How realistic is it to institute in developing countries a tax system solely for efficiency objective, as described above?

First, the normative theorizing implicit in the strictly efficiency-oriented tax structure is based on certain assumptions that may not be valid in the special circumstances of developing countries. As mentioned earlier, it assumes that government is not, and in fact should not, be a major producer in its own right, beyond being a supplier of a few essential public goods.22 Moreover, it assumes that all private individuals are rational and optimizing agents responding to price signals alone (where the market prices reflect true social costs) and that there are no social and institutional determinants of, and constraints on, either market prices or their behavior (which can be removed by government actions).23 Other assumptions are that there is perfect mobility of factors of production and that income distribution is reasonably appropriate without redistributive taxation and expenditure policies of the government.

Second, an efficiency-oriented tax system (especially one that consists of taxes on basic necessities while luxuries could be exempt) will be politically unacceptable.

Third, there is little resemblance between the efficient tax bases consistent with supply-side considerations and the existing tax systems of developing countries, which would suggest the introduction of a completely new tax system. But experience shows that the barriers to changing existing tax systems even modestly tend to be fundamental because of the view that old taxes are good taxes. Moreover, major tax changes profoundly affect capital values and imply sizable income and wealth redistribution (capital-based taxes may already have been capitalized and reflected in asset prices). Therefore, in a real sense, fundamental tax reform to institute a completely new tax system, however desirable that may be from the efficiency point of view, may well be just about impossible in reality.24

Finally, the efficiency-dictated tax system, described above, may not provide enough revenue to run a modern government, especially if a tax on potential income is found to be administratively infeasible.

To conclude: the ingredients of a tax system for efficiency or supply-side objectives are well known, as are the limitations of adopting such a system in the real world. Therefore, in making their recommendations, tax reformers of developing countries not only must take all these factors into account, they must also be aware that attempts at moving existing tax systems in the direction of meeting efficiency and supply-side objectives are likely to be gradual at best.

III. Rate Design for Supply-Side Economics or Optimal Tax Rates

If efficiency in resource allocation is the only aim of taxation, then, as Table 1 shows, there will be a variety of tax rates for the taxed commodities and for individuals. The tax system will not be progressive with respect to individual economic capacities, however measured, and even the tax on accrued incomes would tend to be proportional (flat rate) or perhaps regressive.25 In addition, few judgments, if any, can be made on the optimal levels of tax rates that will prevail in an efficiency-oriented tax system, for they will require complete knowledge of empirical estimates of own- and cross-price elasticities of demand and supply for individual commodities and factors of production, measures of externalities associated with relevant commodities, and so on. As there is little reason to believe that such crucial parameters can be correctly estimated, there is little hope that optimal tax rates can be derived, against which existing tax rates can then be judged.26

A popular supply-sider will argue, and with some validity, that lowering the tax rates, in general, and income tax rates, in particular, from their existing high levels in itself is desirable.27 According to this view, high and progressive income tax rates can simply discourage savings and investment, often without achieving their intended effects on income distribution. Lowering income tax rates and reducing their progressivity can, on the other hand, encourage savings and investment and promote productive effort to such an extent as to generate employment and incomes for the less well-off and, thereby, actually improve equity in the longer run. It can also reduce tax evasion.

The desirability of lowering income tax rates and reducing their progressivity deserves, of course, closer examination by tax reformers in all developing countries where marginal tax rates are considered high.28 However, certain special circumstances of developing countries will have to be borne in mind.

First, given the relatively low standards of living of even the middle-income groups, a reduction of income tax rates might well encourage overall consumption in developing countries more than savings. It might encourage savings by the rich (even in the short run as anticipated by the popular supply-siders), but if economic signals implicit in other economic policies are not correct, such savings can easily flow into unproductive investments, viz., speculation in and hoarding of commodities, foreign exchange, land, housing, and other existing capital assets. The efficiency gains from income tax reforms would, thus, very much depend upon the assumptions made about other economic policy instruments.

Second, lowering income tax rates and reducing their progressivity alone may not be enough to reduce income tax evasion, since in developing countries tax evasion is determined by many factors, the nominal progressivity of tax rates, although important, being only one such factor.29 It remains to be empirically established that an across-the-board reduction in the progressivity and levels of income tax rates would reduce tax evasion and improve tax compliance in developing countries to any great degree, at least in the short run.

Third, in developing countries income inequality is frequently a result of highly skewed land and property ownership. Furthermore, in most of them, education—which accounts for most of the inequality of human capital and which is heavily subsidized by the government—yields extremely high private returns. Higher taxation on the earnings from skewed land and property ownership and on human capital can at once reduce the private windfalls and economic rents from the ownership of such assets, and this can be politically very appealing.

Finally, the degree of progressivity of the income tax system is frequently the result of a political and social consensus, but its interaction with high levels of inflation can raise the progressivity far beyond its intended level. If inflation rates are excessive, as they often are in many developing countries, it may be desirable to adjust the tax system for inflation before tackling the degree of progressivity.

To sum up, there is no theoretical case for progressive income tax rates in a tax system dictated solely by efficiency considerations, but then there is very little of practical value that can be said from theory about the rate structure of a strictly efficient income tax. As modern taxation literature has shown, there is no optimal degree of progression. The optimal degree depends very much upon the form and shape of the social welfare function (comprising equity and efficiency objectives) as well as the form and shape of individual utility functions (as determined by factors such as ability, taste, relative income position, and so on). Consequently, little can be said even theoretically about the degree of progressivity which is of immediate policy relevance. Empirically, the degree of progressivity in taxation frequently reflects the political and social consensus on income redistribution in a given country, and the only circumstance in which it can be justified on efficiency grounds is if it captures scarcity rents or windfall gains.

The inherent conflict between equity and efficiency objectives of taxation has always been well known. Policymakers in developing countries are also aware of this conflict. To resolve it, they frequently tend to have high nominal tax rates but give liberal tax exemptions and concessions to selected taxpayers and sectors. This is obviously inadvisable as such a policy simply compounds the distortionary effects of taxation. A strategy of taxation consistent with the spirit of basic supply-side economics (i.e., removal of tax-induced distortions) would call for broadening the tax base (to reduce the scope of exemptions, tax concessions, and other deductions) while simultaneously lowering income tax rates and applying them uniformly across income categories.30 Most tax economists would agree with such a tax policy prescription of basic supply-side economists. It would simplify the tax system, ensure horizontal equity, and curtail the powers of tax policymakers to erode the tax base in the name of supporting one or more social and noneconomic objectives. Besides, it would also strengthen tax policy as an instrument for stabilization purposes because, with fewer tax preferences and concessions, the effectiveness of tax rate cuts (and increases) as a component of macroeconomic policy would be enhanced.

IV. A Popular Supply-Side Economist Versus an Optimal Tax Economist

“Thus the policy suggestions of the supply side school are fully compatible with the spirit of the huge body of optimal taxation literature,” claims a recent supply-sider.31

This paper may have implied that because supply-side economics attaches a great deal of importance to the objective of efficiency, there is little difference between a popular supply-side economist and a modern optimal tax economist. This is not true. There are at least five major differences.

  • A popular supply-side economist is inherently an elasticity optimist and favors large reductions in tax rates; in contrast, an optimal tax economist assumes little about elasticities in relation to marginal changes in tax rates and considers them to be entirely empirical matters.

  • A popular supply-side economist concerns himself little with the equity objective, horizontal or vertical; in contrast, an optimal tax economist fully concerns himself with equity (vertical, if not horizontal) and, in fact, attempts to optimize between the efficiency and equity objectives of taxation—maximizing a social welfare function by minimizing excess burdens of taxation while achieving a socially desirable redistribution of income through taxation.

  • A popular supply-side economist accepts some progressivity in nominal tax rates on pragmatic grounds, though, in the extreme, he would prefer a flat-rate (or proportional) income tax; in contrast, an optimal tax economist refuses to provide a definitive conclusion on the optimal degree of progressivity, since, according to him, the optimal outcome is highly sensitive to the specification of the social welfare function (incorporating equity objective) and the individual utility functions (incorporating individual tastes). The most robust findings of optimal taxation on this subject have been that marginal tax rates should first increase and then decrease, with those on the highest income becoming zero—in other words, income tax rates should be regressive in the upper-income ranges.32

  • A popular supply-side economist takes the existing tax system as given, including the dominance of income taxation; in contrast, an optimal tax economist is fully concerned with the composition of tax structure and the balance between direct and indirect taxes as well as the structures of both income and commodity taxes.33

  • A popular supply-side economist is perhaps pragmatic enough about tax reform not to want to design the tax structure de novo or to change the status quo; in contrast, an optimal tax economist is not pragmatic at all. The design of optimal tax structures requires a great deal more information than has been, or can ever be, collected. In addition, the implementation of such structures is not even on the horizon, as an optimal tax economist frequently does not concern himself with administrative feasibility (i.e., with the potential for tax avoidance and tax evasion) nor with taxpayers’ preferences or the compliance costs of his proposals about tax designs. For these reasons, the large literature on optimal taxation, though enriching, has yielded few practical policy conclusions and results commensurate with the intellectual resources devoted to it.34

The popular supply-side economist has, therefore, little resemblance to those who belong to the stream of recent theoretical literature on taxation. One common denominator between the two perhaps is that both view the expenditure side of the budget in an unusual manner. The optimal tax economist discusses the problem of optimal taxation on the assumption that the government has a fixed revenue requirement for an unspecified purpose that has no bearing on the utility of individuals. The popular supply-side economist also seems to discuss the problem of taxation on the implicit, if not explicit, assumption that government should provide few goods and services beyond pure public goods. That public expenditures can positively influence the utility of individuals is not an issue in either approach. This may, however, be an unrealistic assumption in the context of developing countries where certain public expenditures on social and economic infrastructure and its maintenance may be positively productive and social welfare enhancing.

V. A Tax System Dictated by Popular Supply-Side Economics: Some Implications

Taxation is in practice an instrument with multiple objectives and will continue to be so despite what economists profess. The conflict between the objectives of equity and efficiency is fundamental. A tax system based solely on efficiency grounds is unrealistic, while that designed solely for equity purposes cannot be justified on allocative grounds. The degree of progressivity will, in practice, continue to be dictated by political and social consensus rather than by the optimizing formulas of tax economists. One solid contribution of supply-side economics has been to remind us that the way out of the conflict between the equity and efficiency objectives of taxation is not to have high and progressive nominal tax rates and generous tax incentives and preferences, as most developing countries do (they achieve neither income redistribution nor desired resource reallocation), but to have as wide a tax base as possible, as well as lower nominal tax rates. Tax reforms along these lines will be consistent with supply-side economics as well as with the same or even a greater degree of income redistribution.

Whether or not rates of taxes on incomes and profits in developing countries should be lowered significantly all at once or simply be restructured to reduce the degree of progression would depend very much upon the height of the present tax rates, government revenue from the existing high tax rates, the validity of the elasticity optimism of the popular supply-side approach in the context of developing countries (i.e., whether lowering tax rates will have much effect on production), and the relevance in the particular circumstances of a developing country of the assumptions on which supply-side theory is based. Various chapters in this volume (especially in Part II) deal with many of these issues in depth, and this chapter has touched upon others. However, should a developing country be serious about adopting the popular supply-side tax policy and lowering its income tax rates significantly, it must take into account the following five considerations.

First, the lowering of income tax rates must be accompanied by reforms in the income tax base, viz., the removal of tax preferences and tax concessions. The removal of narrowly based foreign trade taxes (e.g., export duties) and certain other taxes important to their tax systems (e.g., payroll and other selective taxes) may also be equally, if not more, important on efficiency grounds. High tax rates and narrow and selective tax bases can create distortions, encourage unproductive activities, erode the revenue base, and lower the effective tax rates below the intended nominal tax rates. Tax cuts without reforms in the tax base can introduce more distortions of efficiency and equity than they correct, especially if they result in inflationary finance.

Second, tax rate reductions must be permanent or, at least, be perceived by taxpayers to be so if they are to have significant effect on savings and investment behavior. The theory of rational expectations suggests that investors change their behavior according to their expectations of the costs of capital, including their expectations of future tax rates over the lifetime of an investment. The same holds true for the behavior of savers. Besides, tax rate reductions would have to be substantial if they are to have a marked “net” effect on behavior, especially because selective tax exemptions and concessions, which may have been enjoyed by savers and investors and which may have had some positive economic effect on their behavior, may now be withdrawn from the tax structure.

Third, short-run elasticities frequently tend to be lower than long-run elasticities for a given change in prices; consequently, it would be advisable to expect the full supply-side effects of a reduction of tax rates to become evident only in the longer run.

Fourth, reducing tax rates for supply-side effects (including improving tax compliance and to further other objectives) must go hand-in-hand with government expenditure cuts and reforms of public enterprise pricing, at least in the short run, or until elasticity optimism materializes. Otherwise there will be a growing budget deficit and a likely rise in inflation (depending upon the sources of financing) with its own distortions and unintended economic consequences. For example, if people expect inflation to continue, and interest rates do not adjust with inflation, they will spend rather than save in the current period, thereby negating the effect of tax cuts on savings and investment.

Fifth, the use to which tax revenues are put in developing countries is also relevant. If a large proportion of government expenditure is directed at financing desirable human capital and social and economic infrastructure in an efficient manner, it removes supply bottlenecks, aids the development process, and provides the justification for higher tax rates. On the other hand, if government revenues go toward financing a large and unproductive civil service or nonpriority capital expenditure, they support wasteful consumption rather than capital formation.

In the final analysis, a tax structure for efficiency and supply-side economics calls for fundamental reforms in the existing tax systems of developing countries. The reforms will have to be directed at reducing the distortionary effects of their existing taxes, which would require removing most exclusions and exemptions and widening the tax base, while reducing rates of taxation. In the context of the tax structures prevalent in developing countries, this strategy would apply not only to personal income tax (which is often an unimportant source of revenue in low-income countries) but to all other direct and indirect taxes as well.

ANNEX
Relationship Between Tax Ratio and Growth Rate

A study by Keith Marsden is sometimes quoted by popular supply-siders in the United States as “evidence” in support of the relevance of supply-side tax policy to developing countries.35 This Annex describes and critically appraises the nature of this evidence.

Marsden reviewed the experience of growth and taxation in 20 selected countries during the 1970s and concluded that those with lower taxes experienced more rapid expansion of investment, productivity, employment, and government services, and had better growth rates. The selected countries were grouped into 10 pairs with similar per capita incomes but contrasting tax levels, and their growth rates over the past decade were then compared (see Table 2). Marsden concluded from this evidence that “In all cases, the countries that imposed a lower effective average tax burden on their populations achieved substantially higher real rates of growth of gross domestic product (GDP) than did their more highly taxed counterparts.”36

He analyzed his data further with the help of regression analyses and obtained the following two equations:

N = 20; R2 = 0.449

N = 20; R2 = 0.779′

where

g = GDP growth rate;

t = tax to GDP ratio;

i = investment growth rate; and

n = labor force growth rate.

His multivariable equation (2) had a higher R2 but revealed a relative insignificance of the tax variable. He, therefore, tended to rely on his bivariate equation (1) and concluded that “an increase of one percentage point in the tax/GDP ratio decreases the rate of economic growth by 0.36 percent points.”37

There are, at least, four problems with this evidence. First, some of his tax revenue data are partial and are susceptible to misleading comparisons. The tax revenue data for Japan, for example, have been understated by excluding social security taxes, while the data for Brazil have been understated by excluding all taxes collected by state and local governments.38 As a result, both Japan and Brazil would seem to become “low-tax” countries in his sample by design, while for some other “low-tax” countries, for example, Malawi, Korea, Singapore, and Spain, the data are valid only for late 1960s and early 1970s but not necessarily for the late 1970s or for more recent years.39 Second, his data are on total tax to GDP ratio (“effective average tax burden” on populations, as he puts it) and not on marginal income tax rates, which is the primary focus of popular supply-siders, or even the burden of direct taxes. Third, his sample of 20 countries is not randomly chosen, which is an essential requirement for drawing general and unbiased conclusions. Furthermore, the pairing of the low-tax and high-tax countries is obviously quite arbitrary and bears no relationship whatsoever to the structures of their economies or the other variables that could possibly influence their growth rates. To show how the arbitrary pairing of countries might have influenced his conclusions, Table 3 presents another arbitrary pairing of some of the countries selected by him, with somewhat similar per capita incomes, and the conclusion is very different. For example, now two relatively low-tax countries (Peru and Korea) have very dissimilar growth rates and the same is true of the two relatively high-tax countries (Uruguay and Brazil). On the other hand, two developing countries (Mauritius and Paraguay) now have very different tax ratios but very similar high growth rates. Obviously, no firm conclusions can be derived on the relationship between tax ratios and growth rates from such evidence.

Table 2.Selected Industrial and Developing Countries: Comparative Performance
Per Capita

Income Groups, 1979

(In U.S. dollars)
Total

Tax Revenue1

As Percent

of GDP

(1970s)
Real Average

Annual

Growth Rates of

GDP, 1970-79

(In percent)
Malawi (low tax)}200-30011.86.3
Zaïre (high tax)21.5- 0.7
Cameroon (low tax)}500-60015.15.4
Liberia (high tax)21.21.8
Thailand (low tax)}500-60011.77.7
Zambia (high tax)22.71.5
Paraguay (low tax)}700-1,10010.38.3
Peru (high tax)14.43.1
Mauritius (low tax)}1,100-1,30018.68.2
Jamaica (high tax)23.8- 0.9
Korea (low tax)}1,400-1,70014.210.3
Chile (high tax)22.41.9
Brazil (low tax)}1,700-2,10017.18.7
Uruguay (high tax)20.02.5
Singapore (low tax)}3,800-5,95016.28.4
New Zealand (high tax)27.52.4
Spain (low tax)}4,300-6,35019.14.4
United Kingdom (high tax)30.42.1
Japan (low tax)}8,800-11,95010.625.2
Sweden (high tax)30.92.0
Source: Keith Marsden, “Taxes and Growth,” Finance & Development, Vol. 20 (September 1983), pp. 40-43. See also Keith Marsden, “Links Between Taxes and Economic Growth: Some Empirical Evidence,” World Bank Staff Working Paper No. 605 (Washington, 1983).

Central government tax revenue only.

Including nontax revenue hut excluding social security contributions.

Source: Keith Marsden, “Taxes and Growth,” Finance & Development, Vol. 20 (September 1983), pp. 40-43. See also Keith Marsden, “Links Between Taxes and Economic Growth: Some Empirical Evidence,” World Bank Staff Working Paper No. 605 (Washington, 1983).

Central government tax revenue only.

Including nontax revenue hut excluding social security contributions.

Table 3.Selected Developing Countries: Comparative Performance—Information Rearranged
Per Capita

Income, 19791

(In U.S. dollars)
Total Tax Revenue

As Percent of GDP
Real Average Annual

Growth Rates of GDP,

1970-79

(In percent)
Peru73014.43.1
Korea1,13014.210.3
Uruguay2,10020.02.5
Brazil1,78017.18.7
Mauritius1,11018.68.2
Paraguay1,07010.38.3
Source: Keith Marsden, “Taxes and Growth,” Finance & Development, Vol. 20 (September 1983), pp. 40-43. See also Keith Marsden, “Links Between Taxes and Economic Growth: Some Empirical Evidence,” World Bank Staff Working Paper No. 605 (Washington, 1983).

World Bank, World Development Report, 1981, pp. 134-35.

Source: Keith Marsden, “Taxes and Growth,” Finance & Development, Vol. 20 (September 1983), pp. 40-43. See also Keith Marsden, “Links Between Taxes and Economic Growth: Some Empirical Evidence,” World Bank Staff Working Paper No. 605 (Washington, 1983).

World Bank, World Development Report, 1981, pp. 134-35.

It would have been much better for Marsden to (1) not arbitrarily select only 20 countries and (2) certainly not arbitrarily pair them. Had he carried out a regression analysis of a larger cross-section of developing countries he would have found, much as Rabushka and Bartlett did, that the overall level of taxation as well as the direct tax ratio are positively, and not negatively, correlated with growth rates.40 To be analytically correct, he should, in fact, have carried out a multivariate analysis of growth rates based on an appropriately specified economic model such as Mañas-Antón has done in Chapter 8 in relation to income taxes.

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As described in Chapter 1, basic supply-side economists focus on all aspects of the tax system, while the popular supply-side economists primarily focus on the levels and progressivity of marginal income tax rates. An empirical study frequently quoted in support of the validity of the proposition that lower taxes will encourage economic growth in developing countries is that of Marsden (1983a and 1983b). The Annex to this chapter describes and reviews the methodology underlying this study.

In particular, see Boskin (1973, 1978, 1982); Howrey and Hymans (1980); King (1980); Rosen (1980); Hausman (1981a, 1981b); Keleher (1982); Keleher and Orzechowski (1982); and Evans(1982, 1983).

“Neutrality” in the strictest sense will require that neither relative prices of goods and services nor relative factor rewards should be affected by tax rates or other provisions of the tax system. A less stringent definition of neutrality will involve effective tax rates to be such that they will avoid diversions of labor, savings, investments, etc., to uses that are suboptimal. For a fuller discussion of this subject, see section on “A Neutral Tax System,” below. Even some popular supply-siders have emphasized the objective of neutrality. See Kemp (1981, p. 68), Raboy (1982, p. 58), and Ture (1982, p. 17).

That productive efficiency or ensuring the efficient allocation of resources is desirable frequently goes unquestioned. However, there may be exceptional situations where productive inefficiency rather than efficiency may be “optimal” on certain distributive and allocative grounds. Such situations are described in Dasgupta and Stiglitz (1972) and Mirrlees (1972). They, of course, involve high administrative and informational costs. See Sandmo (1976, p. 48).

See, for example, Musgrave (1959) and Samuelson (1969). The conflict between equity and efficiency in taxation has been well known in literature and has been frequently repeated by economists since the time of Adam Smith. Much of the recent optimal taxation literature, in fact, is devoted to developing a framework for dealing with both simultaneously rather than separately.

Smith (1950, Volume II, pp. 310 and 367). The Laffer curve of supply-side economics seems to draw its inspiration from this quotation from Smith.

Marshall (1948, p. 467) quoted in D. Walker (1970, p. 365).

Pigou (1962, p. x). The optimal taxation literature, in fact, traces its origin to Pigou’s “announcement effects” in estimating the deadweight losses of various taxes. Indeed, Pigou is said to have posed the “Ramsey problem” to Ramsey and helped to develop the efficiency rules relating to taxation.

Simons (1938, pp. 18-19) and (1950).

Some theoreticians, such as Rawls (1971), believed only in the equity objective.

See Goode (1976, especially Chapters 2 and 4).

Market failures, defined as the inability of markets to achieve an efficient allocation of resources, generally arise in cases of goods where (1) private costs and benefits are different from social costs and benefits; (2) prices are higher than marginal costs due to the failure of competition or the existence of monopolies; or (3) benefits of outputs are shared by all individuals, irrespective of whether or not they pay.

Any system of taxation will have an income effect, but a tax is said to be distortionary (or to cause “excess” burden) if it creates distortions in compensated demands. For details of this argument see Atkinson and Stiglitz (1980) and Tresch (1981).

These prices, sometimes called benefit taxes, can be based on the voluntary exchange principle, enunciated by Wicksell and Lindahl. This is particularly valid for “impure” public goods, which do not suffer from the “free rider” problem, that is, where consumers can be identified and preferences can be determined. “Pure” public goods should, on the other hand, be financed through nondiscriminatory and nondistortionary poll taxes. All pure public or nonmarket goods, of course, have a revelation problem requiring the use of demandrevealing mechanisms that are nondistortionary. For some of these mechanisms, see Vickrey (1961, pp. 8-37) and Mueller (1979, pp. 72-84). For any redistribution beyond that implicit in Pareto-optimal taxation, the theory of first best recommends lump-sum transfers only.

An externality exists whenever the action of a given consumer (or a producer) affects, negatively or positively, the utility (or production possibilities) of some other consumer (or producer), so that the marginal social cost of his action differs from the marginal private cost of his action. The appropriate first-best policy in such a case would be to make the former individuals directly compensate the latter financially for the latter’s gains and losses. However, this may not be possible if more than a few individuals are involved.

The presence or absence of pure profits can complicate the optimal tax rules and raise issues concerning the number of degrees of freedom available to the government. Cf., Munk (1978).

In fact, optimal taxation theory is an advance over second-best theory since it allows for nonlinear taxes, which were ruled out by Ramsey. For a brief review of optimal taxation literature, see Sandmo (1976) and Stern (1984).

Poll tax is justified only when the assumption of no migration is made.

For a detailed discussion of this point, see Kay and King (1980, Chapter 6, especially pp. 75-76), Tanzi (1980), and Millward (1983, especially Chapter 2).

Savings will be taxed over the lifetime of a consumer and, if transferred to the next generation, by taxes on inheritances. The case in favor of consumption tax is presented in Fisher and Fisher (1942), Kaldor (1955), Meade (1978), United States, Department of the Treasury (1977), Lodin (1978), and Sumner (1983). For the case against consumption tax, see Pechman (1980) and Musgrave (1983, pp. 23-24).

Cf., Musgrave (1978).

See Shome (Chapter 12) for the potential role of governments in the process of development.

See Ebrill (Chapter 3) for nonprice determinants of the behavior of economic agents.

Cf., Feldstein(1976).

As Pigou (1962, p. x) has concluded, “[If announcement effects are important] the order of merit among tax formulae [will be] first, poll-taxes; second, regressive income taxes; third, proportionate income taxes; fourth, progressive income taxes.”

Even econometric estimates of own-price elasticities from past data are only going to be point estimates and with standard errors attached to them.

The theory underlying this view is that, under certain assumptions regarding the shapes of demand and supply curves, the “excess burden” of a tax, which is not a lump-sum tax, is directly a function of the rate of tax.

See Table A9 in the Statistical Appendix on the extent to which high top marginal income tax rates prevail in developing countries.

A multiplicity of factors, including many nontax factors and factors relating to income tax administration, are said to be responsible for the high levels of income tax evasion found in developing countries. See Richupan (Chapter 6).

Recent reforms of income taxation in India, Indonesia, and Jamaica reflect this strategy. A report of the Treasury Department has stressed this strategy for the reform of the U.S. tax system as well. See United States, Department of the Treasury (1984).

Raboy (1982, p. 59).

Some progressivity of income tax might, however, be acceptable to them—provided that the rate structure can be made a function of distribution of skills and abilities and there is a negative income tax at the bottom of the income scale—but the degree of progressivity will be nowhere near what will be indicated solely by the application of minimum sacrifice principle.

Cf., Atkinson (1977) and Atkinson and Stiglitz (1980). On the whole, an income tax on all incomes that is approximately linear (a constant marginal tax rate with an exemption below which negative supplements are payable) is considered optimal. A linear income tax on labor incomes only and without an exemption is simply equivalent to a linear commodity tax (a proportional rate on all goods) and is very much distortionary. On the other hand, nonlinear income taxes (proportional rate income tax with an exemption) are considered preferable, given equity and efficiency considerations, over differentiated taxes on goods and services, except where there is an interaction between the supply of labor and the marginal rates of substitution between goods. This conclusion, however, ignores the problems of administration, evasion, horizontal equity, and taxpayer’s preferences between taxes.

One of the major policy-oriented conclusions of optimal taxation literature is that taxes on elastic tax bases should best be avoided or, at best, kept low. It is in this spirit that the case is made for lower taxation of capital incomes vis-à-vis labor incomes and of married women vis-à-vis married men.

Marsden (1983a). The conclusions of this paper are available in Marsden (1983b and 1984).

Marsden (1983a, p. 2).

Marsden (1983a, p. 8).

During the 1970s, tax revenues of state and local governments in Brazil accounted for about 8 percent of GDP. See International Monetary Fund (1985, p. 81).

The tax to GDP ratio in these countries for more recent years are as follows (see International Monetary Fund (1985, pp. 80-81)):

Malawi (1980)18.14
Korea (1978)17.27
Singapore (1983)19.81
Spain (1983)27.33

See Rabushka and Bartlett (1985, pp. 81-82).

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