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University of Toronto Scarborough
Economics for Management Studies

ECMC31 TOPIC 4 OPTIMAL TAXATION 1. Terms and Concepts 2. Optimal Taxes on Consumption 3. Optimal Taxes on Labour 1. TERMS AND CONCEPTS 4. Optimal Taxes on Capital 5. Tax Evasion LEARNING OBJECTIVES 1. What are the essential features of optimal taxes 2. What factors influence tax evasion 1 2 Requirements Requirements, continued optimal taxes balance efficiency with fairness fairness principles are subjective and may include o horizontal equity o vertical equity efficiency o benefit principle o minimum excess burden o minimum tax evasion o inter-generational equity o minimum compliance costs o minimum administrative costs equity = fairness 3 4 Defining optimal taxes economics => prescribes efficient taxes value judgments => prescribe fairness specified values + => prescribe optimal taxes 2. OPTIMAL TAXES economics ON CONSUMPTION different values will lead to different versions of optimal taxes fairness principle illustrated in the remainder of this topic is utilitarianism o place equal value on everyones utility o try to maximize the sum of everyones utility = maximize average utility 5 6 Efficient commodity taxes K = savings decision your current income from capital came from a past savings decision of yours => K = fixed in following short-run analysis L = labour supply decision Z = leisure decision MAXT = total time available = L + Z L changes when choice of leisure Z changes thus I = wL + rK = w(MAXT - Z) + rK = wMAXT wZ + rK define potential income I* income from working 247 plus your income from past investment decisions = wMAXT + rK, so I*= fixed if income I is fixed, I is also what we spend on consumption, i.e. I = PxX + PyY a uniform, general, ad-valorem commodity tax looks like a lump-sum tax => no EB so I* = PxX + PyY + wZ I = wL + rK = what we earn fixed spending on spending on income from capital ownership income from work income consumption leisure A uniform ad-valorem tax on all consumption but if L or K also fall in response to commodity plus leisure would act like a lump sum tax tax, then tax base I also falls and EB > 0 with EB = 0. However, we cant tax leisure. 7 8
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