INTRODUCTION tax problem-can legitimately be set to the side. As a consequence, all that remains to examine are what may be viewed as the distinctive effects of the original policy instrument under consideration. These effects may accordingly be assessed on efficiency grounds alone because any stan- dard social welfare function will favor a reform package that increases ficiency while leaving distribution unaffected In this setting, it is correct to follow simple first-best commands like the Samuelson cost-benefit test, the Pigouvian prescription to set pollution taxes and subsidies equal to marginal external costs and ben qualifications that will be explored)despite second-best concerns about distribution and labor supply distortion that have occupied increasingly complicated literatures, work that often does not incorporate the in- come tax and that frequently attends only to distribution or only to distortion-which is quite dangerous given the inevitable tradeoff be tween the two and, relatedly, the failure to apply a social welfare fund tion. By comparison, the method adopted here enables analysis that i more streamlined and intuitive and, at the same time, more rigorous and reliable Furthermore, because the same technique can be utilized for such a wide range of seemingly disparate problems-from commodity taxation to transfer taxation to public goods to regulation-there are substantial economies of effort. In addition, greater specialization is facilitated be cause inquiries into specific subjects, properly framed distribution. neutral income tax adjustments, can confine attention to distinctive features. Studies of cigarette taxation can concentrate on the merits of discouraging smoking, evaluations of transfer taxation on the virtues of encouraging consumption by donors rather than by donees, assessments of infrastructure projects on their effects on productivity, and appraisals of environmental measures on the direct costs of different modes of regulation and their environmental consequences. Other researchers can focus on the distribution-distortion tradeoff itself. which is done most directly in the context of the original optimal income tax problem,one that would benefit from greater attention to a number of little-explored yet important variations. There are, of course, interactions in some in stances, but it will be seen that these, too, are clarified by the proposed approve 02_Kaplow_cho1_p001-p010ndd
introduction 3 tax problem—can legitimately be set to the side. As a consequence, all that remains to examine are what may be viewed as the distinctive effects of the original policy instrument under consideration. These effects may accordingly be assessed on effi ciency grounds alone because any standard social welfare function will favor a reform package that increases effi ciency while leaving distribution unaffected. In this setting, it is correct to follow simple fi rst-best commands like the Samuelson cost-benefi t test, the Pigouvian prescription to set pollution taxes and subsidies equal to marginal external costs and benefi ts, and public sector pricing at marginal cost. This is so (subject to qualifi cations that will be explored) despite second-best concerns about distribution and labor supply distortion that have occupied increasingly complicated literatures, work that often does not incorporate the income tax and that frequently attends only to distribution or only to distortion—which is quite dangerous given the inevitable tradeoff between the two and, relatedly, the failure to apply a social welfare function. By comparison, the method adopted here enables analysis that is more streamlined and intuitive and, at the same time, more rigorous and reliable. Furthermore, because the same technique can be utilized for such a wide range of seemingly disparate problems—from commodity taxation to transfer taxation to public goods to regulation—there are substantial economies of effort. In addition, greater specialization is facilitated because inquiries into specifi c subjects, properly framed using distributionneutral income tax adjustments, can confi ne attention to distinctive features. Studies of cigarette taxation can concentrate on the merits of discouraging smoking, evaluations of transfer taxation on the virtues of encouraging consumption by donors rather than by donees, assessments of infrastructure projects on their effects on productivity, and appraisals of environmental measures on the direct costs of different modes of regulation and their environmental consequences. Other researchers can focus on the distribution-distortion tradeoff itself, which is done most directly in the context of the original optimal income tax problem, one that would benefi t from greater attention to a number of little-explored yet important variations. There are, of course, interactions in some instances, but it will be seen that these, too, are clarifi ed by the proposed approach. 02_Kaplow_Ch01_p001-p010.indd 3 2_Kaplow_Ch01_p001-p010.indd 3 10/16/2007 11:21:13 AM 0/16/2007 11:21:13 AM
As the foregoing discussion indicates, the methodological focus of this book is conceptual and normative. Therefore, only occasional at tention will be given to the extensive empirical work that bears impor- tantly on ultimate policy recommendations but not as much on how analysis should be structured. Additionally, macroeconomic and politi cal considerations are largely ignored. Finally, except for occasional il lustrative purposes, specific policy proposals are not examined. The purpose here is to enhance understanding of how analysis should b conducted and of what research agenda is implied thereby. It will never theless be apparent throughout the book that this approach has sub- stantial and sometimes unconventional policy implications The framework for analysis is presented more fully in Part I. Chapter 2 discusses the case for an integrated view of various forms of taxation and associated subjects in public economics and begins to explore what this view entails Substantial attention is devoted to how distribution. neutral income tax adjustments can be utilized to facilitate the analysis of tax, expenditure, and regulatory policies. Chapter 3 further develops the need for making the social objective explicit, presents the standard formulation of the social welfare function that will be employed through out the book, and discusses a range of social judgments about redistri- bution and how differences among them relate to subsequent analysis. Part II begins application of the framework by examining the opti- mal income taxation problem and related issues. Chapter 4 presents standard models and results for linear and nonlinear (labor)income taxation that will be drawn upon in subsequent chapters. Even readers already conversant with this work will likely find some nuances of interest. Chapter 5 elaborates and extends the classical analysis along a number of dimensions. Some matters are familiar. like the relevance of administration and enforcement, whereas others have received less attention, such as ability-based taxation, the complication that income may signal different preferences rather than just abilities, and the impli cations of interdependent preferences. Many of these topics warrant further research; in some instances, preliminary lines of inquiry are sketched 02_Kaplow_ch01_p001-p010ndd 4 1016/20071121:13A
4 chapter 1 As the foregoing discussion indicates, the methodological focus of this book is conceptual and normative. Therefore, only occasional attention will be given to the extensive empirical work that bears importantly on ultimate policy recommendations but not as much on how analysis should be structured. Additionally, macroeconomic and political considerations are largely ignored. Finally, except for occasional illustrative purposes, specifi c policy proposals are not examined. The purpose here is to enhance understanding of how analysis should be conducted and of what research agenda is implied thereby. It will nevertheless be apparent throughout the book that this approach has substantial and sometimes unconventional policy implications. ••• The framework for analysis is presented more fully in Part I. Chapter 2 discusses the case for an integrated view of various forms of taxation and associated subjects in public economics and begins to explore what this view entails. Substantial attention is devoted to how distributionneutral income tax adjustments can be utilized to facilitate the analysis of tax, expenditure, and regulatory policies. Chapter 3 further develops the need for making the social objective explicit, presents the standard formulation of the social welfare function that will be employed throughout the book, and discusses a range of social judgments about redistribution and how differences among them relate to subsequent analysis. Part II begins application of the framework by examining the optimal income taxation problem and related issues. Chapter 4 presents standard models and results for linear and nonlinear (labor) income taxation that will be drawn upon in subsequent chapters. Even readers already conversant with this work will likely fi nd some nuances of interest. Chapter 5 elaborates and extends the classical analysis along a number of dimensions. Some matters are familiar, like the relevance of administration and enforcement, whereas others have received less attention, such as ability-based taxation, the complication that income may signal different preferences rather than just abilities, and the implications of interdependent preferences. Many of these topics warrant further research; in some instances, preliminary lines of inquiry are sketched. 02_Kaplow_Ch01_p001-p010.indd 4 2_Kaplow_Ch01_p001-p010.indd 4 10/16/2007 11:21:13 AM 0/16/2007 11:21:13 AM
INTRODUCTION Chapter 6, on commodity taxation, is especially important for this book because it presents the most elemental formalization of much of the integrative theme. Using the distribution-neutral approach, Atkin son and Stiglitz's(1976) aforementioned result on the inefficiency of differential commodity taxation is extended to the more general case in which the initial income tax is arbitrary rather than optimal and to cases involving partial reforms. A direct implication is that luxury taxes well as widely employed exemptions, such as those from a Vat for ex- penditures on necessities, are inefficient tools for achieving distributive objectives. Qualifications to this analysis and its precise relationship to the assumptions and well-known principles associated with Ramsey taxation are discussed. The results of this chapter are a centerpiece for much of the subsequent analysis in the book because the method of distributively offsetting income tax adjustments is a generic one. Ac cordingly, the logic is not restricted to commodity taxation and thus can be used to reach important and sometimes surprising conclusions regarding public goods, regulation, and other forms of taxation(such as of private transfers). As will be discussed at various points in the book, many policy instruments are formally quite similar to commodity taxation, so the unity of analytical approaches to these disparate sub jects and similarity of results should not, upon reflection, be viewed as surprising Part Ill completes the integrated framework by taking account of government expenditures. Chapt ts, sup- plementing the simplified treatment in standard optimal income tax analysis Much study of transfer programs and of taxation is undertaken in isolation, which results in a deceptive picture regarding redistribu- tion and the incentives faced by lower-income individuals. More broadly existing views about optimal treatment at the bottom of the income distribution have conflicting elements: Extremely high effective mar- ginal tax rates(largely from phase-outs of transfer payments) are widely condemned, whereas optimal income tax analysis suggests that high marginal rates at low income levels are attractive even though they lead the lowest-ability individuals not to work. These competing elements are reconciled, and the results are used to determine the optimal form of categorical assistance, that is, how levels of assistance and marginal tax rates(including phase-outs)should differ across groups, such as the 02_Kaplow_Cho1_p001-p010ndd 5
introduction 5 Chapter 6, on commodity taxation, is especially important for this book because it presents the most elemental formalization of much of the integrative theme. Using the distribution-neutral approach, Atkinson and Stiglitz’s (1976) aforementioned result on the ineffi ciency of differential commodity taxation is extended to the more general case in which the initial income tax is arbitrary rather than optimal and to cases involving partial reforms. A direct implication is that luxury taxes as well as widely employed exemptions, such as those from a VAT for expenditures on necessities, are ineffi cient tools for achieving distributive objectives. Qualifi cations to this analysis and its precise relationship to the assumptions and well-known principles associated with Ramsey taxation are discussed. The results of this chapter are a centerpiece for much of the subsequent analysis in the book because the method of distributively offsetting income tax adjustments is a generic one. Accordingly, the logic is not restricted to commodity taxation and thus can be used to reach important and sometimes surprising conclusions regarding public goods, regulation, and other forms of taxation (such as of private transfers). As will be discussed at various points in the book, many policy instruments are formally quite similar to commodity taxation, so the unity of analytical approaches to these disparate subjects and similarity of results should not, upon refl ection, be viewed as surprising. Part III completes the integrated framework by taking account of government expenditures. Chapter 7 examines transfer payments, supplementing the simplifi ed treatment in standard optimal income tax analysis. Much study of transfer programs and of taxation is undertaken in isolation, which results in a deceptive picture regarding redistribution and the incentives faced by lower-income individuals. More broadly, existing views about optimal treatment at the bottom of the income distribution have confl icting elements: Extremely high effective marginal tax rates (largely from phase-outs of transfer payments) are widely condemned, whereas optimal income tax analysis suggests that high marginal rates at low income levels are attractive even though they lead the lowest-ability individuals not to work. These competing elements are reconciled, and the results are used to determine the optimal form of categorical assistance, that is, how levels of assistance and marginal tax rates (including phase-outs) should differ across groups, such as the 02_Kaplow_Ch01_p001-p010.indd 5 2_Kaplow_Ch01_p001-p010.indd 5 10/16/2007 11:21:13 AM 0/16/2007 11:21:13 AM
6 disabled and those capable of work. It appears that groups that are typi cally subject to high(low) marginal rates should optimally face low (high)rates. In addition, increasingly popular work inducements are considered, and it is revealed that most existing and proposed schemes may deviate, perhaps substantially, from optimality. Chapter 8 addresses government expenditures on goods and services A proper view of distribution requires attending to how overnment expenditures are financed and how the combination of expenditure and finance affects distribution and distortion. Using the distribution-neutral income tax adjustments introduced in chapter 2 and analyzed in chap- ter 6, it is demonstrated that concerns about both distribution and the fact that finance involves income taxation with its associated labor sup ply distortion can largely be ignored in determining the optimal provi- sion of public goods. In addition, the feedback(if any) of public good provision on optimal redistributive taxation is examined; that is determined how changing the level of public goods affects the optimal extent of redistribution. The analysis of these issues also elucidates-and in some ne cases dissolves--challenges that confront attempts to measure the distributive incidence of public policies, and it offers a new perspec- tive on debates about conceptions of benefit taxation. Finally, the analy sis of public goods is modified to produce analogous results regarding all manner of government regulation, such as that of the environment, which raises similar concerns regarding distributive effects and labor supply distortion. Again, the results depart, sometimes substantially from those in the pertinent literature Part IV considers other forms and dimensions of taxation. Chapter 9 moves beyond the implicitly static, one-period model used in classical optimal income taxation analysis-actually, the analysis of optimal labor income taxation--to consider the taxation of capital income. Use of the distribution-neutral approach of chapters 2 and 6 to compare dif- ferent levels of capital taxation serves to clarify and elaborate the point originally advanced by atkinson and Stiglitz( 1976) that capital taxation is equivalent to differential commodity taxation, in this instance of commodities in different time periods, and thus is inefficient in the basic case. A range of qualifications to this result are explored, including the possibility that individuals savings decisions do not reflect neoclas sical maximizing behavior. The conclusions are used to illuminate the 02_Kaplow_Cho1_p001-p010ndd 6
6 chapter 1 disabled and those capable of work. It appears that groups that are typically subject to high (low) marginal rates should optimally face low (high) rates. In addition, increasingly popular work inducements are considered, and it is revealed that most existing and proposed schemes may deviate, perhaps substantially, from optimality. Chapter 8 addresses government expenditures on goods and services. A proper view of distribution requires attending to how government expenditures are fi nanced and how the combination of expenditure and fi nance affects distribution and distortion. Using the distribution-neutral income tax adjustments introduced in chapter 2 and analyzed in chapter 6, it is demonstrated that concerns about both distribution and the fact that fi nance involves income taxation with its associated labor supply distortion can largely be ignored in determining the optimal provision of public goods. In addition, the feedback (if any) of public goods provision on optimal redistributive taxation is examined; that is, it is determined how changing the level of public goods affects the optimal extent of redistribution. The analysis of these issues also elucidates—and in some cases dissolves—challenges that confront attempts to measure the distributive incidence of public policies, and it offers a new perspective on debates about conceptions of benefi t taxation. Finally, the analysis of public goods is modifi ed to produce analogous results regarding all manner of government regulation, such as that of the environment, which raises similar concerns regarding distributive effects and labor supply distortion. Again, the results depart, sometimes substantially, from those in the pertinent literature. Part IV considers other forms and dimensions of taxation. Chapter 9 moves beyond the implicitly static, one-period model used in classical optimal income taxation analysis—actually, the analysis of optimal labor income taxation—to consider the taxation of capital income. Use of the distribution-neutral approach of chapters 2 and 6 to compare different levels of capital taxation serves to clarify and elaborate the point originally advanced by Atkinson and Stiglitz (1976) that capital taxation is equivalent to differential commodity taxation, in this instance of commodities in different time periods, and thus is ineffi cient in the basic case. A range of qualifi cations to this result are explored, including the possibility that individuals’ savings decisions do not refl ect neoclassical maximizing behavior. The conclusions are used to illuminate the 02_Kaplow_Ch01_p001-p010.indd 6 2_Kaplow_Ch01_p001-p010.indd 6 10/16/2007 11:21:13 AM 0/16/2007 11:21:13 AM
INTRODUCTION 7 choice between income and consumption taxation, wealth taxation, and corporate income taxation, and the results are extended to address un certain capital income, capital levies and certain tax regime transitions, and the taxation of human capital. As suggested earlier, the analysis and some of the results in this chapter differ markedly from much of the existing literature on capital taxation because such work employs Ramsey-type models that assume(often implicitly) the infeasibility of income taxation Chapter 10 analyzes the taxation(or subsidization) of private trans fers between individuals. Although transfer taxation is often understood as a revenue source and an important redistributive supplement in the fiscal system as a whole, these views are misconceived if one joins such taxation with a distributively offsetting income tax adjustment. Then the question becomes, Regarding individuals at a given level of income (say, very high), should their overall tax burden be relatively higher or lower if their marginal dollar is given to descendants rather than spent on themselves to live more opulently? This formulation immediately suggests an entirely different orientation toward the taxation of volun- tary transfers. The analysis is complicated by two sets of factors: First, gifts directly affect two individuals, donor and donee, in a manner that qualitatively differs from expenditures on ordinary consumption; this feature gives rise to two species of externalities and has subtle distribu- tive implications that are qualitatively distinct from those usually con templated. Second, gifts are induced by a wide array of motives that may have diverse implications for behavior and welfare. The distribution neutral approach neutralizes what many consider to be the most perti nent considerations and brings into view these important factors that previously have been largely hidden. The analysis is also applied to ad ditional subjects, including determination of the optimal policy toward charitable giving, a problem that is also cast in a new light. Chapter 1l examines aspects of social insurance that are related to the issues addressed elsewhere in the book. First, purely redistributive aspects of social security are noted. It is observed that ordinary redistri- bution through social security can generally be assimilated to redistri- bution under the income tax Then attention turns to more distinctive redistributive dimensions, notably that social security retirement schemes depend on lifetime income(with consideration of how marginal tax 02_Kaplow_Cho1_p001-p010ndd 7
introduction 7 choice between income and consumption taxation, wealth taxation, and corporate income taxation, and the results are extended to address uncertain capital income, capital levies and certain tax regime transitions, and the taxation of human capital. As suggested earlier, the analysis and some of the results in this chapter differ markedly from much of the existing literature on capital taxation because such work employs Ramsey-type models that assume (often implicitly) the infeasibility of income taxation. Chapter 10 analyzes the taxation (or subsidization) of private transfers between individuals. Although transfer taxation is often understood as a revenue source and an important redistributive supplement in the fi scal system as a whole, these views are misconceived if one joins such taxation with a distributively offsetting income tax adjustment. Then the question becomes, Regarding individuals at a given level of income (say, very high), should their overall tax burden be relatively higher or lower if their marginal dollar is given to descendants rather than spent on themselves to live more opulently? This formulation immediately suggests an entirely different orientation toward the taxation of voluntary transfers. The analysis is complicated by two sets of factors: First, gifts directly affect two individuals, donor and donee, in a manner that qualitatively differs from expenditures on ordinary consumption; this feature gives rise to two species of externalities and has subtle distributive implications that are qualitatively distinct from those usually contemplated. Second, gifts are induced by a wide array of motives that may have diverse implications for behavior and welfare. The distributionneutral approach neutralizes what many consider to be the most pertinent considerations and brings into view these important factors that previously have been largely hidden. The analysis is also applied to additional subjects, including determination of the optimal policy toward charitable giving, a problem that is also cast in a new light. Chapter 11 examines aspects of social insurance that are related to the issues addressed elsewhere in the book. First, purely redistributive aspects of social security are noted. It is observed that ordinary redistribution through social security can generally be assimilated to redistribution under the income tax. Then attention turns to more distinctive redistributive dimensions, notably that social security retirement schemes depend on lifetime income (with consideration of how marginal tax 02_Kaplow_Ch01_p001-p010.indd 7 2_Kaplow_Ch01_p001-p010.indd 7 10/16/2007 11:21:13 AM 0/16/2007 11:21:13 AM