Public Finance, 2nd Edition

of distorting taxation is recognized, horizontal and vertical equity must be

more broadly deWned in terms of tax burdens, as we have done. Conversely,

equating tax payments with tax burdens must imply both a Wrst-best policy

environment and lump-sum taxation.

We will adopt a Wrst-best framework and equate tax payments with tax

burdens to focus strictly on the equity issues involved with the ability-to-pay

principles. This is at best an uneasy convenience, however. The problem is

that the ability-to-pay principles lead to choices of broad-based taxes that are

almost certainly not lump sum, so that it is impossible to ignore distortions

entirely. In particular, the federal personal income tax contains a number of

second-best distortions whose equity implications can only be understood in

terms of the broader tax-burden interpretation of horizontal and vertical

equity. Thus, we will occasionally stray from the Wrst-best assumptions.

HORIZONTAL EQUITY

From Horizontal Equity to the Ideal Tax Base

Mainstream public sector economists do not agree on which tax base best

satisWes the principle of horizontal equity. They do agree, however, on the

proper way to think about what the ideal tax base should be. The line of

reasoning from horizontal equity to the ideal tax base always relies on the

same three principles of tax design. The disagreement occurs in applying the

third principle, which describes the Wnal step to the tax base.

The Three Principles of Tax Design

People Bear the Tax Burden

The Wrst principle of tax design is that people ultimately bear the burden

of any tax no matter what is actually taxed. For example, corporate income

taxes and sales taxes are levied on business Wrms in the United States, but

the fact that a business Wrm pays $X million in taxes is of little consequence.

The interesting questions in terms of tax equity are which people Wnally

bear the burden of these taxes. Is some or all of the burden ``passed forward''

to the consumers of the Wnal product through higher prices, ``passed back'' to

labor employed by the Wrm through lower wages, borne by the stockholders

of the Wrm, or borne by third parties not directly associated with the Wrm?

Social well being is directly related to individuals' utility functions, not to

production relationships, and any tax eventually burdens people in their roles

as consumers or as suppliers of factors, or both.

Individuals Sacrifice Utility

The second principle of tax design is that individuals ultimately sacriWce

utility when they pay general taxes, so that the ideal tax base would be

11. APPLYING FIRST-BEST PRINCIPLES OF TAXATIONÐWHAT TO TAX AND HOW 337