14 - The second-best theory of taxation with general production technologies and many consumers

Abstract

This chapter presents a discussion on the second-best theory of taxation with general production technologies and many consumers. The chapter discusses the second-best analysis in two directions to make it more responsive to real-world economies. The first direction is to incorporate general production technologies with increasing cost production possibilities frontiers. The other direction is to consider the case of many consumers with different tastes and different marginal social welfare weights. With general technologies, producer prices vary as government policy variables move society along (or inside of) its production-possibilities frontier. Also, pure economic profits or losses are possible and have to be accounted for in a general equilibrium framework. As a consequence of these features, the marginal loss from taxation depends on production derivatives as well as consumption derivatives. The many-consumer economy brings the social welfare function back into the analysis in a fundamental way such that distinctions between the equity and efficiency implications of government policy become blurred. In addition, the concept of a general aggregate income measure of tax loss becomes problematic.