The Theory of Tax Reform

Optimal Taxation and the Theory of Tax Reform

The optimal tax approach has been criticized in several respects. In this section, we explain the tax reform approach as an alternative method of tax policy. One could argue that the Ramsey-type optimal tax formula is not useful from the viewpoint of realistic applicability. Namely, the government may not have precise information about the utility function and market equilibrium conditions. Moreover, it may be difficult for the government to change the tax system drastically because of various constraints such as political privileges on existing tax rates and conflicts among interest groups. Thus, the government can only change tax rates gradually and partially. It may also be difficult to find a social welfare function that is acceptable for most people in a democratic society.

Feldstein (1976) criticized the optimal taxation approach based on these difficulties. He proposed an alternative tax reform approach that gradually reforms the existing tax system toward the desirable target,

In other words, the optimal tax approach investigates the optimal tax system freely from the beginning, while the tax reform approach is concerned with the gradual change of the actual tax system.

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