Revenue-maximizing tax rates in personal income taxation in the presence of consumption taxes: a note

ABSTRACT

This article computes revenue-maximizing tax rates in personal income taxes in the presence of consumption taxes. It finds that the traditional Laffer analysis, which neglects the effects of marginal tax rates on consumption, overestimates the magnitude of revenue-maximizing tax rates. The bias caused by this oversight is computed.

KEYWORDS:

• Marginal tax rates
• Laffer curve
• consumption taxes
• tax revenue
• tax behaviour

JEL CLASSIFICATION:

• D11
• D61
• H21
• H24
• H2
• H31

Acknowledgement

The author expresses his gratitude to the Spanish Institute for Fiscal Studies as well as to national research projects ECO2012-37572 and UCM-BSCH GR/12. Useful comments from Norman Gemmell are also acknowledged.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹ Using different approaches, Saez (2004), Giertz (2009), Creedy (2011, chapter 13) and Saez et al. (2012) present detailed discussions on this issue.

² In a recent paper by Carey et al. (2015), the implications of changes in the consumption tax rate on the elasticity of taxable income (ETI) is explored. For the case of a quasi-linear utility function, these authors find that ETI is unaffected by the level of the consumption tax rate. This, however, does not imply that the PIT Laffer curve is also unaffected.

³ As highlighted by Creedy and Gemmell (2006), Equation 1 and the analytical expression of the effective threshold result directly from rearranging the expression: which represents formally the application of the tax schedule to taxable income, .

⁴ This derives directly from the fact that . For the explicit form of the elasticity functions and , see the Appendix.

⁵ This median Spanish taxpayer in 2008 is characterized by the following parameter values = 0.1150, , .