A Critical Examination of the Desirable Characteristics of a Tax System

Efficiency

An efficient tax system is supposed to minimize its impact on relative prices in order to keep production efficiency and resource allocation undisrupted. It was believed that in certain circumstances the optimal commodity taxation is appropriate for bringing efficiency to the economy; however the distortionary taxes and the imperfection of the assumptions of optimal commodity taxation deviates economics choices from the efficient outcome.

In the context of the optimal taxation rule, the Inverse Elasticity Rule declares that the proportional rate of tax on a good should be inversely related to its price elasticity of demand, so that there should be more taxes on low elasticity of demand goods. The Ramsey Rule also support on this fact by stating that the compensated demand for each good is reduced in the same proportion relative to the before-tax position. Since necessities such as food and housing that demand by customers is less sensitive to the price changes compared to luxuries, the above two rules suggested that an effective tax system should bears heavily on necessities. Yet in the real economy, a heavy tax burden on necessities will cause a greater burden on low-income consumers than the high-income consumers. Therefore the optimal taxation rules are irrational when put into practice as the equality criterion is omitted from the assumption. In despite all that, Ramsey rule does explain the positive economics effects resulted of high excise duties on alcohol, tobacco and petrol as they are not necessities but with less elasticity of demand.

Distortionary taxes are the detrimental resistance for achieving an efficient outcome, hence arguments from the perspective of efficiency suggest that governments should use distortionary taxes as less as possible so as to minimize its negative effects and avoid excess burden. The lump-sum tax and poll taxes is preferred because using lump sum tax can avoid deadweight losses and poll taxes have no distortionary cost. But the distortionary taxation is introduced due to inequality aversion and the regressive impact of poll taxes. When an excise tax is imposed on firms, the tax may rebate to households which cause the equilibrium output, consumption and employment falls. Although households still consume all the resources that are produced, the amount of resources is smaller, therefore the welfare shrinks. Generally people respond to increased taxation by working harder to reduce the fall in post-tax incomes. But there is a case that the results are on the contrary to the tax designer's purpose. If an excise tax is imposed on households is too high that the real return to each additional unit of labour supply is largely reduced, then households have incentives to substitute consumption by leisure. This tax discourages labour supply, which distort the economy and disturbed production efficiency.

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