Commodity Taxation

1st Welfare Theorem

Competitive eq is pareto efficient , this is violated if there is not a competitive
market or there are externalities , but can be corrected using Pigou taxation
2nd Welfare Theorem
Any pareto efficient eq can be obtained by use of lump-sum taxation and
transfers. If this is not possible we use a second best measure of distortive
taxation on economic activity which have equity gains but efficiency losses

Problem is how to set taxes to minimise the cost of raising a certain level
of revenue
Do this by adopting a SWF to represent state preferences and then
maximising this w.r.t the revenue constraint

Ramsey Taxation Model

Assumptions
1.
2.
3.
4.
5.
6.
7.
8.

Labour only factor of prod

Consumer price (q) is producer price (p) plus tax (t) : q =p + t
Single household model
Individuals choose consumption vector (x) and labour supply ( l ) so as to
max a quasi-concave U fn subject to a budget constraint
No redistribution
Govt needs to raise a certain level of revenue
CRS and Perfect Comp
No envy within the economy

L=

Note that :
Therefore :

Additional tax revenue per unit of U foregone should be the same

regardless of what tax has been changed
Roys Identity:

Sub in:

This result depends on the existence of cross price effects :

If no cross price effects involved then the following occurs:

Rearrange and divide through by qk:

Inverse Elasticity Rule

In the absence of cross price effects , the proportional rate of tax for a
good should be inversely proportional to the elasticity of demand
This result appears counter- intuitive because it suggests that necessities
should have the highest taxes but this result is only derived from a single
household model

If there is cross price effect use the Slutsky eq:

Sub this into xk = . to get:

Rearrange this to obtain:

is independent of the good chosen and holds for each good