GEORGE MASON UNIVERSITY SCHOOL of LAW

In order to assess the efficiency of a tax, we should examine its effect on the behavior of individuals. In general, the less a tax affects behavior, the more efficient it is thought to be. The standard example of a non-distorting tax is a lump-sum tax, which does not change with the behavior of the taxpayer. However, this article demonstrates that behavioral distortions can and do arise from a change in even a lump-sum tax. The only truly non-distortionary tax would be one based on utility itself. Utility, which has been used as a norm for distributional analysis, is also the ideal base for efficiency analysis. In fact, any reasonable attempt to describe a minimally distortive basis of taxation will significantly resemble the notion of a tax on utility. Therefore, utility itself is the best basis for evaluation of the efficiency of a tax. Such a tax has many additional features which make it more useful for analytical purposes than lump sum taxes. Income taxes and consumption taxes have assumed a very prominent place in public finance in large measure because they are thought to be relatively efficient bases for taxation. (Tresch, 2003) These taxes are considered efficient because it is believed that the behavioral response to these taxes is considered to be less elastic to marginal increases in the rate of taxation when compared with other bases of taxation such as excise taxes on goods and services. (Ramsey, 1927, Tresch, 2003) This lower behavioral response is commonly believed to result in lower losses to welfare than most other potential tax bases. However, as explored in this article, these conclusions are based on a number of assumptions about the utility functions of individuals which may not be correct. * Associate Professor, George Mason University School of Law. The author would like to thank Michael Abramowicz, Joseph Bankman, Edward McCaffrey, Francesco Parisi, Mark Pingle, David Schizer, and Jeff Strnad for their comments on an earlier version of this paper. The author would like to thank the Lawrence Cranberg Foundation and the Law and Economics Center for their financial support. The primary intent of this article is to put forth three very simple points. First, the standard arguments about how one measures the efficiency of income and other taxes are incomplete. This does not mean they are not useful, but they ignore many important aspects of behavior. Second, these lacunae can cause our analysis to be blind to important distortionary elements of a tax. If we do not understand what causes behavior, it will be difficult to prevent from distorting behavior unintentionally. Third, it is therefore necessary for any welfare analysis of taxation to study the actual utility functions of individuals. It is here that behavioral economics, experimental economics and other empirical economic research can have a significant impact on our analysis. In particular, this article will discuss how research tends to indicate that wealth or income enters the utility function not as single number (or scalar), but rather in multiple parts (i.e., as a vector). As part of the discussion, this article demonstrates that the standard against which to measure the efficiency of any tax should be judged should not be a lump-sum or head tax, but rather it should be a tax based on utility itself. The article shows how such a tax could be crafted in principle, and demonstrates that the strong assumptions of cardinality commonly made in the discussion of such taxes (e.g., Feldstein, 1976) are not necessary in order to use a tax on utility as a standard for an efficient tax. Therefore, unlike the discussions of such taxes for distributional purposes, the usefulness of such taxes for efficiency analysis is not dependent on the interpersonal comparisons of utility. Of course, actually imposing a tax based on utility at the present time is perhaps even more unrealistic than a lump-sum tax; however, as discussed in section II, it is more analytically useful.