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Published in: Social Choice and Welfare 4/2014

01-04-2014 | Original Paper

Tax differentiation, lobbying, and welfare

Authors: Sandro Brusco, Luca Colombo, Umberto Galmarini

Published in: Social Choice and Welfare | Issue 4/2014

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Abstract

To what extent a taxing authority should be granted the power to impose different tax schedules to different groups of taxpayers? Although the policy maker aims at maximizing social welfare, her tax policy may be distorted by the lobbying activity of taxpayers. In this political environment we characterize the conditions under which social welfare can be increased by restricting the set of tax instruments available to the policy maker; i.e., the scope of tax differentiation. We show that full differentiation is more costly, in terms of welfare distortions, when the lobbies are asymmetric in size, while minimal differentiation is more costly when the tax bases are asymmetric across different groups.

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Appendix
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Footnotes
1
The classical textbook account of the optimal taxation paradigm is Atkinson and Stiglitz (1980) and, more recently, Myles (1995). Two important and recent contributions on the characterization of the optimal non-linear income tax are Saez (2001, 2002).
 
2
Optimal tax theory typically ignores the costs of administering the tax system. ‘Simplicity’ and ‘efficient administration’ are often informally invoked among the merits of ‘flat taxes’ (see Keen and Kim 2008, for a thorough account of the long lasting debate over flat taxes). Only few theoretical studies account for the fact that a more complex tax structure involves higher administration costs (see, e.g., Yizhaki 1979; Mayshar 1991).
 
3
Somewhat related is the literature investigating the link between redistribution through public expenditure and electoral systems (Myerson 1993; Lizzeri and Persico 2003; Crutzen and Sahuguet 2009). In these models, complexity refers to the differentiation of public transfers to different groups of voters.
 
4
The policy maker in charge of tax policy can belong either to the central or to the local level of government. As for the latter, the literature on fiscal federalism has identified several reasons for limiting the tax autonomy or discretion of local governments, but none has yet focused on the one addressed in this paper. These include efficiency arguments, like horizontal tax competition among governments belonging to the same layer (see, e.g., Wilson 1986; Zodrow and Mieszkowski 1986), and vertical tax competition between different layers of government (Keen 1998; Keen and Kotsogiannis 2002; Dahlby and Wilson 2003). The literature offers also arguments in favor of fiscal autonomy at the local level. One classical argument (see, e.g., Tiebout 1956; Brennan and Buchanan 1980) is that fiscal differentiation promotes competition among local governments that hinders their tendency to act as Leviathan revenue maximizers, thanks to the constraints arising from taxpayers’ mobility. Another argument (see, e.g., Oates 1972) is that fiscal policy at the local level is more efficient than at the central level in the presence of inter-regional preference heterogeneity for public goods, because local governments match fiscal policy to local preferences while the central government implements a uniform policy in all jurisdictions.
 
5
As an alternative to income taxes, our analysis could have been focused on the differentiation of commodity taxes, since different groups of taxpayers may have different consumption patterns and therefore different incentives to lobby for the structure of indirect tax rates. See Diamond and Mirrlees (1971), and Atkinson and Stiglitz (1972), for commodities tax differentiation in an optimal taxation framework with benevolent governments.
 
6
In most political economy applications, lobbying behavior is modeled using the ‘buying influence’ approach of the common agency games developed by Dixit et al. (1997) and Grossman and Helpman (1994, 2001). In this paper, we use a simpler model of lobbying behavior in the spirit of Becker (1983), that can be interpreted as a reduced form of the common agency models.
 
7
See Sect. 5 for an example that uses this class of functions.
 
8
Note that the strategy space of the policy maker includes the fiscal policy instruments but not the weights used to compute the average welfare in the social welfare function. The lobbying weights defined in Eq. (6) depend on the groups’ lobbying efforts in a way that reflects the features of the institutional and political environment, all of which cannot be controlled by the policy maker. Quite obviously, if one were to give a benevolent policy maker the power to choose the groups’ weights, she would always choose their true weights \(\theta _{j}\), with the result that lobbying would be always ineffective in equilibrium.
 
9
We discuss more in depth the nature of the policy maker’s objective function in Sect. 6.
 
10
Immonen et al. (1998) and Viard (2001) examine the optimal differentiation of income tax schedules among sub-groups of taxpayers in a classical optimal taxation framework, with endogenous labor supply and a benevolent policy maker that maximizes a social welfare function. The complexity of tax systems has also been investigated by Hettich and Winer (1988) and Warskett et al. (1998) in a probabilistic voting framework.
 
11
This does not mean that group \(j\) does not pay taxes, since \(S_{j}^{**}\) could be negative.
 
12
Notice that if the contribution to a group’s activity is not compulsory, the no free riding assumption also implies that the cost of lobbying sustained by the group is shared among its heterogenous members in such a way as to provide positive incentives to contribute to all its members.
 
13
While these assumptions may look restrictive, we show in Sect. 6 that in the present setting they are instead rather innocuous.
 
14
The remark made at the end of Sect. 3.1 also applies here: the tax and subsidy policy described in Proposition 3 appears to be plausible only when \(r\) is sufficiently large. In this case, \( r \) also has an impact on the tax rate and a large \(r\) makes sure that the tax rate remains reasonable (in particular, it is not above 100 %).
 
15
That the inequality holds follows immediately from the fact that the expression on the right hand side of the inequality can be interpreted as the residual sum of squares in a OLS regression of \(\beta \) on \(B\) for the entire population. The left hand side is in turn the sum of the residual sum of squares of the OLS regressions for each group \(j\).
 
16
When \(\theta _{j}=\frac{1}{J}\)—i.e., all groups have the same size—there is no distortion in the weights (i.e., \(q_{j}=\theta _{j}\)) and the only difference between FTD and MTD comes from the lobbying cost, which is strictly positive Footnote 16 continued
under FTD and equal to zero under MTD. When there is asymmetry in group size, then FTD has the additional cost of increasing variance.
 
17
The derivation details of Eqs. (43) and (44), as well as of Eqs. (47) and (48) below, are available from the authors upon request.
 
18
Observe that \(\zeta \) is not a preference parameter of the policy maker, but rather an exogenous characteristic of the political environment.
 
19
We are not concerned with the impact on social welfare of the distribution of lobbying efforts among group members, since it is the result of a process of voluntary bargaining.
 
20
Note that the case \(W_{{\mathrm{net}}}^{*{\mathrm{FTD}} }(0)=W_{{\mathrm{net}}}^{*{\mathrm{MTD}}}(0)\) occurs when the first two moments of the distributions \(f_{j}\left( \beta ,B\right) \) are the same, as assumed in Proposition 6.
 
21
Note that the rule of uniform sharing of the lobby costs turns out to be incentive compatible for each lobbying group. This notwithstanding, all the remarks made above about free riding continue to apply.
 
22
The analytical details supporting the above discussion are available from the authors upon request.
 
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Metadata
Title
Tax differentiation, lobbying, and welfare
Authors
Sandro Brusco
Luca Colombo
Umberto Galmarini
Publication date
01-04-2014
Publisher
Springer Berlin Heidelberg
Published in
Social Choice and Welfare / Issue 4/2014
Print ISSN: 0176-1714
Electronic ISSN: 1432-217X
DOI
https://doi.org/10.1007/s00355-013-0753-z

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