Public Finance, 2nd Edition

Chapter 11 moves from theory to practice. It concludes our Wrst-best

analysis with a discussion of the practical problems that legislators and

administrators wrestle with in designing broad-based taxes such as income,

wealth, sales, and value added taxes. The focus throughout is the extent to

which mainstream Wrst-best principles can inform tax policy in the United

States.

DESIGNING BROAD-BASED TAXES: THE

ECONOMIC OBJECTIVES

Economists have proposed Wve economic objectives that governments should

strive for in designing broad-based taxes:

1. Ease of administration and taxpayer compliance

2. Minimize dead-weight loss

3. Promote long-run economic growth

4. Maintain Xexibility

5. Honor society's norms of fairness or equity

The Wrst objective takes precedence in the sense that if a tax does not meet

both parts of this objective it simply will not be used. Ease of administration

refers to the ability of a department of revenue to collect the taxes due easily

and economically, at a small fraction of the cost of the revenues raised. Ease of

taxpayer-compliance refers to the taxpayers' ability to understand the tax

code and pay the taxes owed with minimal eVort, record keeping, and cost.

The two are closely related, as taxpayers must be able and willing to pay their

taxes for them to be collected easily. The need to satisfy the Wrst objective

explains why less developed countries rely mostly on sales taxes, import

duties, and other forms of business taxes rather than personal income and

wealth taxes to raise revenue. Broad-based personal taxes such as in income

tax cannot be used if a large percentage of the population cannot read or write.

Objectives two and three refer to the eYciency properties of taxes, the

second to static eYciency, and the third to dynamic eYciency. Regarding static

eYciency, we saw in Chapter 2 that buyers and sellers must face the same

market prices to achieve the pareto-optimal conditions. Taxes distort markets

by driving a wedge between the prices faced by buyers and sellers, thereby

generating dead-weight eYciency losses. The goal of tax design is to minimize

the dead-weight eYciency losses for any given amount of revenues collected.

The dynamic eYciency problem is that taxes may also reduce incentives to save

and invest, to the detriment of long-run economic growth. The goal is to

maintain incentives for saving and investment to the fullest extent possible.

A related problem is to ensure that tax policy keeps the economy as close as

possible to the Golden Rule of Accumulation, the capital/labor ratio that

maximizes consumption per person for any given rate of growth.

332 DESIGNING BROAD-BASED TAXES: THE ECONOMIC OBJECTIVES