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A Net Welfare Benefit Approach to Optimal Taxation

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  • Cristian F. Sepulveda

    (Farmingdale State College, SUNY)

Abstract

This paper challenges the widespread notion that the labor income tax is an inherently distortionary tax instrument. Optimal tax theory considers the lump-sum tax as the only efficient or non-distortionary tax instrument. This conclusion depends on two (often implicit) assumptions: one is that the economy is operating at the optimal welfare maximizing solution, where the marginal cost of tax revenue is equal to its marginal benefit; and the other that public expenditure has no effect on taxpayers’ budget constraints. However, for a government program to be worthwhile, total benefit must be greater than total cost, and it is easy to find examples where budget constraints are affected by public expenditure. This paper shows that, when the two assumptions are relaxed, the combined use of labor income and lump-sum taxes may allow a representative taxpayer to reach greater levels of welfare than the use of a lump-sum tax alone.

Suggested Citation

  • Cristian F. Sepulveda, 2018. "A Net Welfare Benefit Approach to Optimal Taxation," International Center for Public Policy Working Paper Series, at AYSPS, GSU paper1822, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University.
    • Handle: RePEc:ays:ispwps:paper1822
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    File URL: https://icepp.gsu.edu/files/2018/10/paper1822.pdf
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    References listed on IDEAS

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    1. Bohanon, Cecil E & Van Cott, T Norman, 1986. "Labor Supply and Tax Rates: Comment," American Economic Review, American Economic Association, vol. 76(1), pages 277-279, March.
    2. Charles L. Ballard & Don Fullerton, 1992. "Distortionary Taxes and the Provision of Public Goods," Journal of Economic Perspectives, American Economic Association, vol. 6(3), pages 117-131, Summer.
    3. Gwartney, James & Stroup, Richard, 1983. "Labor Supply and Tax Rates: A Correction of the Record," American Economic Review, American Economic Association, vol. 73(3), pages 446-451, June.
    4. Auerbach, Alan J. & Hines, James Jr., 2002. "Taxation and economic efficiency," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 3, chapter 21, pages 1347-1421, Elsevier.
    5. Gahvari, Firouz, 1986. "Labor Supply and Tax Rates: Comment," American Economic Review, American Economic Association, vol. 76(1), pages 280-283, March.
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