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TOPIC: optimal taxation

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TOPIC EIGHTOPTIMAL TAXATION8.1: TOPIC OBJECTIVESBy the end of this topic learner should be able to: Explain optimal taxation Explain the rules for optimal commodity and income taxation8.2 OPTIMAL TAXOptimal taxes also referred to as allocatively efficient taxes will have no impact on the allocationof resources other than those impacts specifically intended to overcome market failure. Thus suchtaxes do not lead to inefficient use or reallocation of resources from optimal uses. Optimal taxationshould therefore be interpreted as taxation that does not alter the relative prices of outputs andinputs. Such taxes will only appropriate the economic rent earned by a factor.Economic rent is defined as:- The excess earned by a factor of production over the sum necessary to induce it to do itswork (the Ricardian definition) or- The excess earnings over the amount necessary to keep a factor in its present occupation(the Paretian definition).The Ricardian definition applies to natural resources such as coal, oil and gas, which have noalternative use if left in the ground.IllustrationConsider two separate oil deposits whose product is sold under perfectly competitive conditionsand whose factor supply is perfectly elastic, but whose costs differ as depicted in figure 8.1.Deposit 1 is represented by MC1 and AC1 and Deposit 2 by MC2 and AC2.The least-cost rate of output is the same for both deposits at q1, but costs are assumed to be higherfor deposit 2 because

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