Chapter 15 Pareto efficient and optimal taxation and the new new welfare economics

For more than a hundred years, economists have attempted to show that progressive taxation can be justified on more fundamental principles. Among the earliest of such attempts was that of Edgeworth (1868, 1897), who tried to show that utilitarianism (combined with two other assumptions) implied progressivity. His argument was simple: he postulated that all individuals had the same utility of income function and that they exhibited diminishing marginal utility. As social welfare has been simply the sum of the utility functions of all individuals, it immediately followed that the decrease in social welfare from taking a dollar (or a pound) away from a rich person is less than the decrease in social welfare from taking a dollar away from a poor person. With the advent of the New Welfare Economics in the 1930s, interest in optimal taxation waned: interpersonal utility comparisons of the kind employed in utilitarianism were viewed to be inadmissible. The new New Welfare Economics is distinguished by two features: first, unlike much of the old New Welfare Economics and unlike the earlier Utilitarian analysis, it does not assume that the government has at its disposal the information required to make lump-sum redistributions and second, it identifies who is able to pay higher taxes at least partly by using endogenous variables, such as income or consumption.