Public Finance, 2nd Edition

tion'' (1971).

3

Explorations of optimal taxation under the second assumption

are a more recent phenomenon.

4

We will defer discussion of restricted optimal

taxation until Chapter 15 when we consider an important subset of that

literature, the theory of optimal income taxation. Mirrlees' ``An Exploration

in the Theory of Optimum Income Taxation'' is the seminal article on optimal

income taxation.

5

3. Tax reformÐHolding tax revenues (or the government budget con-

straint) constant, what is the change in social welfare from substituting one

set of distorting taxes for another? Once again, the literature on this question

is voluminous, with the seminal article by Corlett and Hague, ``Comple-

mentarity and the Excess Burden of Taxation.''

6

Most of the formal analysis of these three questions employs general

equilibrium models speciWed in terms of prices. Therefore, we will switch at

this point from quantity models to price models in order to familiarize the

reader with the most common second-best methodology.

GENERAL EQUILIBRIUM PRICE MODELS

General equilibrium price models can be rather complex or extremely simple

depending upon the assumptions made regarding the nature of demand

and the underlying production technology for the economy and whether

the economy is static or dynamic. Choices on demand range from one-

consumer-equivalent economies to many-person economies with interper-

sonal equity rankings determined by a Bergson±Samuelson social welfare

function. The key choice with respect to production technology is whether

production exhibits linear or general technology and, if the latter, whether or

not the technology is constant returns to scale. The choice of production

technology also has direct implications for the way in which market clearance

3

F. P. Ramsey, ``A Contribution to the Theory of Taxation,'' Economic Journal, March

1927; P. Diamond and J. Mirrlees, ``Optimal Taxation and Public Production'' (2 parts; Part I:

Production EYciency and Part II: Tax Rules), American Economic Review, March, June 1971.

Two excellent surveys of the optimal tax literature are A. Sandmo, ``Optimal Taxation,'' Journal

of Public Economics, July±August 1976; D. Bradford and H. Rosen, ``The Optimal Taxation of

Commodities and Income,'' American Economic Association Papers and Proceedings, May 1976.

Finally, P. Diamond and D. McFadden, ``Some Uses of the Expenditure Function in Public

Finance,'' Journal of Public Economics, Vol. 3, 1974, contains an excellent analysis of some of the

second-best tax issues analyzed in this chapter.

4

Dixit presents a lucid analysis of restricted taxation using the model to be developed in this

chapter in A. Dixit, ``Welfare EVects of Tax and Price Changes,'' Journal of Public Economics,

February 1975. Also see A. Dixit and K. Munk, ``Welfare EVects of Tax and Price Changes: A

Correction,'' Journal of Public Economics, August 1977.

5

J. Mirrlees, ``An Exploration in the Theory of Optimum Income Taxation,'' Review of

Economic Studies, April 1971.

6

W. Corlett and D. Hague, ``Complementarity and the Excess Burden of Taxation,''

Review of Economic Studies, Vol. 21(1), No. 54, 1953±1954.

13. THE SECOND-BEST THEORY OF TAXATION IN ONE-CONSUMER ECONOMIES 401