This article throws light upon the three main criterions for defining the concept of optimal taxation. The criterions are: 1. Minimization of Resource Cost 2. Equity Criteria 3. Efficiency Criteria.
Criteria # 1. Minimization of Resource Cost:
A tax system usually involves cost of collection to the authorities and a resource cost to the taxpayers.
However, in deciding on alternative taxpayers, usually the collection cost on the part of the tax authorities are alone considered. The cost to the taxpayers is usually ignored. Tax payment involves a cost to the taxpayers in terms of money and other resources.
When a tax is imposed, it affects the total resource base of a taxpayer leading to a re-allocation of his resources to honor the payment of tax. The time, manner and method of payment exert a resource allocation cost as far as the taxpayer is concerned.
Hence an optimal taxation should always aim at minimizing its resource cost. We must judge the economy of a tax not merely by the relative cost of its administration but also by the economic effect of the tax on the taxpayers.
The authorities should test the relative effect of the different tax upon the resource endowment, thrift, initiative etc. of the individuals before framing a suitable tax mix.
Criteria # 2. Equity Criteria:
Justice in the distribution of tax burden is an important criteria of optimal taxation. How can we attain a just and equitable allocation of tax burden? We have, in detail, analyzed the concept of equity and its measurement.
Dating back from early times different approaches were conceived by fiscal theorists to frame suitable criteria for judging equity aspect of different taxes. However, no uniformity of opinion has been arrived regarding this issue.
Different fiscal theorists propounded the cost of service principle, benefit principle and ability to pay principle as yardsticks to measure equity in tax distribution. Each approach has its own merits and limitations.
Criteria # 3. Efficiency Criteria:
Economic efficiency is an important criteria to judge the best mix of taxation. Here no, one tax, can be considered as better than other taxes, regarding the question as to what combination of taxes would be the best from an efficiency point of view. This is the so called optimal tax problem.
Tax mix should consist of taxes which produce minimum distortions in resource allocation. In other words, tax system should generate minimum possible deadweight to the system as a whole.
The optimal taxation criteria are based on three interrelated decision governing the tax structure of a country.
(a) The decision as to the aggregate volume of taxation and its composition between direct and indirect taxation.
(b) The composition of direct tax rate schedule and
(c) The composition of indirect tax rate schedule.
The efficiency of commodity taxation is usually considered in terms of its resources allocation effect. The best resource allocation usually considered in welfare economics is that of Pareto optimality.
A resource allocation was Pareto efficient, if no one could be made better off, without someone else being made worse off. In judging tax structure, we again use pareto efficiency.
A Pareto efficient tax structure is one such that there exists no alternative tax structure which can make some individuals better off, without making other individuals worse off. An optimal tax structure, given a particular social welfare, function, is the Pareto efficient tax structure which maximizes the social welfare function.
Different social welfare functions will generate different optimal tax structure. However, this resource optimality criterion ignores the possibility that the addition in efficiency may exceed the reduction in it through such a shift.
Keeping aside the Pareto optimality, one solution to the optimal taxation is that of imposing lump sum taxes. If all individuals were identical and were treated for tax purposes identically, a lump sum tax would be the only efficient tax.
It will not affect neither the marginal cost of production to the producer’s non marginal utilities of purchases to the consumers. Any other tax would introduce distortions. Hence, by lump sum tax, the government could raise the same amount of revenue and make each individual better off. In the real world, things are more complicated.
In terms of income, marginal utility schedule etc. Individuals differ; government wishes to redistribute income on the basis of equity. Moreover, government wishes to make different people pay different taxes. Hence, all those decisions would have its distributive and welfare repercussions.
In the case of indirect taxation, Pareto optimality may not be taken as the criteria for efficiency. Pareto optimality ignores the widespread existence of externalities. Moreover an increase in saving, and investment pattern can accelerate the pace of economic development.
Both these probabilities are ignored under Pareto optimality. Hence uniform taxation of all goods at equal percentage rates would amount to raising the same tax revenue on a lump sum basis. This is so because all taxpayers, experience a proportionate reduction in their incomes.
Hence, this tax has no resource allocation effect. Thus any tax on an input that is not uniform across all firms, or any tax on an output that is not uniform across all firms, result in the economy not being productively efficient.
On the other hand, if a variation in demand elasticity’s is allowed for commodities cannot be taxed at uniform rates. Hence a lump sum tax will not affect the productive efficiency and resource allocation process.
In developing countries, in which there are many barter transactions, and in which level of keeping records is low, it is difficult to enforce an income tax. In such a situation, commodity taxation must be relied on to redistribute income and to ensure that burden of taxation is equitably distributed.
In optimal taxation social welfare and efficiency aspect of taxation should be given importance. Moreover, trade-off between equity and efficiency objectives of taxation should be maintained.