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Welfare Effects of Tax and Price Changes Revisited

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  • Knud Jørgen Munk

    (School of Economics and Management, University of Aarhus, Denmark)

Abstract

Dixit’s 1975 paper "Welfare Effects of Tax and Price Changes" constitutes a seminal contribution to the theory of tax reform analysis within a second-best general equilibrium framework. The present paper clarifies ambiguities with respect to normalisation which have led to misinterpretation of some of Dixit’s analytical results. It proves that a marginal tax reform starting from a proportional tax system will improve social welfare if it increases the supply of labour, whatever the rule of normalisation adopted, and shows that this result provides the key to understanding what determines the optimal system of commodity taxation as reflected in the Corlett and Hague analysis of optimal taxation in an economy with two produced commodities. Recasting work by Deaton (1981b), it generalises, using an alternative definition of the complementarity between consumption and leisure, to an economy with many commodities the insight that the optimal tax system is determined as a trade-off between two objectives: 1) to encourage the supply of labour to the market, and 2), to limit the distortion of the pattern of consumption of produced commodities. This insight cannot be illustrated by simulation studies using standard additive separable utility functions. However, extending work of Atkinson and Stern (1980, 1981) the paper presents a parameterised utility function with explicit representation of the use of time, the CES-UT, which allows a flexible representation of the relationship between consumption and leisure. This functional form is used to provide a quantitative illustration of the trade-off which defines the optimal tax system and thus desirable directions of tax reform.

Suggested Citation

  • Knud Jørgen Munk, 2008. "Welfare Effects of Tax and Price Changes Revisited," Economics Working Papers 2008-03, Department of Economics and Business Economics, Aarhus University.
  • Handle: RePEc:aah:aarhec:2008-03
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    File URL: https://repec.econ.au.dk/repec/afn/wp/08/wp08_03.pdf
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    References listed on IDEAS

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    1. Munk, Knud Jorgen, 1978. " Optimal Taxation and Pure Profit," Scandinavian Journal of Economics, Wiley Blackwell, vol. 80(1), pages 1-19.
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    Cited by:

    1. Knud MUNK, 2008. "On the Use of Border Taxes in Developing Countries," EcoMod2008 23800093, EcoMod.

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    More about this item

    Keywords

    Public economics; optimal taxation; tax reform; tax simulation; distance functions; CGE models;
    All these keywords.

    JEL classification:

    • H2 - Public Economics - - Taxation, Subsidies, and Revenue

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