The Equity-Efficiency Trade-Off in the Presence of Distorting Taxation

Abstract

The purpose of the present study is to demonstrate how distortions that arise from taxation could affect consumers’ behaviour and working time, which might prevent Pareto’s maximisation process from achieving the objectives of optimal trade-off between equity and efficiency. A utility maximisation model is built up and the first-order conditions are manipulated to reach an equilibrium between the MRS and the MRT. The validity of model is then tested. In drawing a comparison of actual with optimal (in)direct tax rates, we find that most of the countries considered have formulated a tax policy that favors equity over efficiency, in terms of a static model, even though the introduction of the dynamic model provides a less clear-cut outcome.