A Model of the Optimal Tax Mix Including Capital Taxation
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A Model of the Optimal Tax Mix Including Capital Taxation John Revesz 1
# International Atlantic Economic Society 2020
Abstract This paper uses a three-tax linear model to study the optimal tax mix numerically. The three aggregate taxes relate to labour, capital and commodities. The most striking result is that with a linear expenditure system based on econometric estimates, indirect (i.e. commodity) taxation dominates the optimal tax mix, with over 80% of tax revenue coming from indirect taxes. Although some analytical justification is presented for this surprising result, it should be tested numerically using other econometrically estimated utility-demand systems. Comprehensive computational modelling of the optimal tax mix has been absent from the literature. In light of the results presented here, there appears to be considerable scope for further research in this area. From a theoretical perspective, a major innovation in this paper is the introduction of capital taxation into a static tax mix model. The analytical part of the paper provides approximate predictions for optimal linear tax rates, called the modified inverse elasticity rule. Using these formulas, explanations are provided for the dominance of indirect taxation in the optimal tax mix. Keywords Optimal taxation . Capital taxation . Income taxation . Indirect taxation JEL H21 . H23 . H26 . C63
Introduction The subject of the optimal tax-mix covers a wide range of models. Among the three main type of taxes examined in this paper (commodities, labour and capital), there Electronic supplementary material The online version of this article (https://doi.org/10.1007/s11293-02009676-0) contains supplementary material, which is available to authorized users.
* John Revesz [email protected]
1
Australian Public Service, Canberra, Australia
Revesz J.
are different modes and shapes of taxes for each. This paper will focus on the case when there is only one type of tax in each category. Further, it is assumed that each tax is proportional to the corresponding quantity. In other words, the model is fully linear. The full linearity of the model distinguishes it from earlier analytical tax-mix models in the literature, such as Atkinson and Stiglitz (1976) and much of Mirrlees (1976). These earlier models focused on non-linear taxes on commodities and labour. Apart from full linearity, the present model can also incorporate static capital taxation, an option that was not included in earlier tax-mix models. One of the principal conclusions from this paper is that under the linear expenditure system (LES), over 80% of optimal tax revenue will be generated through consumption tax, with income tax and capital income tax accounting for only a minor portion. In this paper, the terms indirect tax and consumption tax are used interchangeably. Consumption tax refers to a single uniform tax on all commodities. Indirect taxation covers also different tax rates on various goods. The conclusion about the dominance of consumption tax applies even more to indirect t
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