The Economics of Taxation This page intentionally left blank The Economics of Taxation Bernard Salanie´ The MIT Press Cambridge, Massachusetts London, England Thistranslation(2003bytheMassachusettsInstituteofTechnology OriginallypublishedinFranceunderthetitleThe´oriee´conomiquedelafiscalite´ byEco- nomica,Paris (2002byEconomica All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storageandretrieval)withoutpermissioninwritingfromthepublisher. This book was set in Palatino on 3B2 by Asco Typesetters, Hong Kong and was printedandboundintheUnitedStatesofAmerica. LibraryofCongressCataloging-in-PublicationData Salanie´,Bernard. [The´oriee´conomiquedelafiscalite´.English] Theeconomicsoftaxation/BernardSalanie´. p. cm. Enl.translationof:The´oriee´conomiquedelafiscalite´. Includesindex. ISBN0-262-19486-4(alk.paper) 1.Taxation. I.Title. HJ2307.S26 2002 336.2—dc21 2002035595 Contents Foreword ix Introduction 1 I The Effects of Taxation 13 1 Tax Incidence 15 1.1 Partial Equilibrium 16 1.1.1 The Effect of Payroll Taxes 16 1.1.2 The General Analysis of Partial Equilibrium 19 1.2 General Equilibrium 23 1.2.1 The No-Taxation Economy 23 1.2.2 Introducing Taxes 24 1.2.3 General Remarks 26 1.2.4 Infinitesimal Analysis 27 1.2.5 Final Remarks 33 2 Distortions and Welfare Losses 35 2.1 The Effects of Taxation 38 2.1.1 Labor Supply 38 2.1.2 The Effects of Taxation on Savings 45 2.1.3 Taxation and Risk-Taking 49 2.2 Welfare Losses 52 2.3 Conclusion 57 II Optimal Taxation 59 3 Indirect Taxation 63 3.1 Ramsey’s Formula 63 3.1.1 An Informal Approach 63 3.1.2 The General Model 64 vi Contents 3.1.3 Some Special Cases 69 3.2 Productive Efficiency 73 4 Direct Taxation 79 4.1 The Emergence of the Model 79 4.2 Mirrlees’s Model 83 4.2.1 The Rawlsian Case 84 4.2.2 The General Approach 87 4.2.3 The Quasi-linear Case 91 4.3 Generalizations 96 4.4 Simulations 103 5 Mixed Taxation 111 5.1 The Negative Income Tax 111 5.2 Is Indirect Taxation Useful? 113 5.3 Criticisms 117 6 The Taxation of Capital 121 6.1 Applying Classical Results 123 6.2 The Overlapping Generations Model 124 6.3 The Zero Capital Taxation Result 126 6.4 Capital Accumulation 129 6.5 Capital Taxation with an Infinite Horizon 137 6.6 The Incidence of Capital Taxation 141 6.7 Conclusion 142 7 Criticisms of Optimal Taxation 147 7.1 Horizontal Equity 149 7.2 Tax Reforms 152 7.3 Administrative and Political Issues 155 III Some Current Debates 159 8 Low-Income Support 161 8.1 Measuring Poverty 162 8.2 Private Charity and Public Transfers 163 8.3 The Main Benefits 166 8.3.1 Guaranteed Minimum Income 167 8.3.2 The Negative Income Tax 168 8.3.3 Low-Wage Subsidies 168 8.3.4 The Minimum Wage 170 Contents vii 8.4 The Lessons from Theory 171 8.4.1 The Negative Income Tax 171 8.4.2 Low-Wage Subsidies 176 8.4.3 The Guaranteed Minimum Income 179 8.4.4 The Minimum Wage 179 8.5 Empirical Evaluations 181 8.6 Recent Reforms 184 9 The Consumption Tax 187 9.1 Equivalences between Taxes 187 9.2 The Comprehensive Income Tax 188 9.3 The Consumption Tax in Practice 190 10 Environmental Taxation 193 10.1 Optimal Green Taxes 196 10.1.1 The First-Best Case 196 10.1.2 The Second-Best Case 198 10.2 Is There a Double Dividend? 200 Appendixes A Some Basic Microeconomics 207 A.1 Consumer Theory 207 A.1.1 Hicksian and Marshallian Demands 207 A.1.2 The Slustky Equations 209 A.1.3 Interpretation 210 A.2 Producer Theory 211 A.2.1 The Producer’s Problem 211 A.2.2 Factor Demands 211 A.2.3 The Special Case of Constant Returns 213 B Optimal Control 215 Index 219 This page intentionally left blank Foreword This book is a somewhat expanded translation of my The´orie e´cono- mique de la fiscalite´, published by Economica in Paris. It originates in a course taught at ENSAE and at the University of Chicago. I have greatly benefited from the reactions of the students who went through these courses. I thank without implicating Arnaud Buisse´, Dominique Bureau, Paul Champsaur, Pierre-Andre´ Chiappori, Maia David, Ste´phane Gauthier, Anne Laferre`re, Guy Laroque, Thomas Piketty, Jean-Charles Rochet, Franc¸ois Salanie´, Jean-Luc Schneider, AlainTrannoy,andespecially PhilippeChone´ fortheircommentson a first version of this text. I am also grateful to Christian Gourie´roux and six anonymous reviewers for their comments.