19 Aug 2009Working Paper Summaries

Optimal Taxation in Theory and Practice

by N. Gregory Mankiw, Matthew Weinzierl and Danny Yagan

Are developments in the theory of taxation improving tax policies around the world? The optimal design of a tax system is a topic that has long fascinated economic theorists and flummoxed economic policymakers. This paper explores the interplay between tax theory and tax policy. It identifies key lessons policymakers might take from the academic literature on how taxes ought to be designed, and it discusses the extent to which these lessons are reflected in actual tax policy. The authors find that there has been considerable change in the theory and practice of taxation over the past several decades—although the two paths have been far from parallel. Overall, tax policy has moved in the directions suggested by theory along a few dimensions, even though the recommendations of theory along these dimensions are not always definitive. Key concepts include:

Where large gaps between theory and policy remain, the harder question is whether policymakers need to learn more from theorists, or the other way around. Both possibilities have historical precedents.
Given the worldwide trend toward tax systems with flatter tax rates, it is at least arguable that the movement toward flatter taxes is consistent with prescriptions from theory.
Among OECD countries, top marginal rates have declined, marginal income tax schedules have flattened, and commodity taxes are more uniform and are typically assessed on final goods.
On the other hand, some results from optimal tax theory cannot be easily identified in actual policy and seem unlikely to be found there anytime soon. Trends in capital taxation are mixed, and rates are still well above the zero level recommended by theory.
Some of theory's more subtle prescriptions, such as taxes that involve personal characteristics, asset testing, and history dependence, remain rare.

Author Abstract

We highlight and explain eight lessons from optimal tax theory and compare them to the last few decades of OECD tax policy. As recommended by theory, top marginal income tax rates have declined, marginal income tax schedules have flattened, redistribution has risen with income inequality, and commodity taxes are more uniform and are typically assessed on final goods. However, trends in capital taxation are mixed, and capital income tax rates remain well above the zero level recommended by theory. Moreover, some of theory's more subtle prescriptions, such as taxes that involve personal characteristics, asset-testing, and history-dependence, remain rare in practice. Where large gaps between theory and policy remain, the difficult question is whether policymakers need to learn more from theorists, or the other way around. 35 pages.