A Simple Model of Optimal Tax System : Taxation, Measurement and Uncertainty

The neglect of administrative issues is a serious limitation of optimal tax theory, with implications for its practical applicability. We focus on an important class of administrative problems, namely that the tax bases are measured with some error. We also consider the full set of tax instruments. We find that consumption taxes can perform the 'social insurance role of taxation', a role previously ascribed only to income taxes. A combination of income and consumption taxes can hedge income and measurement-error risks better, relative to the imposition of either type of tax alone. The optimal tax rate is increasing in the precision with which the corresponding tax base is measured. The taxpayer engages in precautionary savings in response to income uncertainty and measurement problems. Differential commodity taxes tailored to the measurability characteristics of the different tax bases dominate uniform commodity taxes. However, as an economy becomes large, optimal taxes converge to uniform (or flat rate) taxes