Do Voters Know Best? The Political Economy of Optimal Taxation

Abstract

This paper investigates the empirical implications of optimal taxation models in the presence of political institutions. Conventional economic theory suggests that the optimal rate of taxation is sensitive to the underlying assumptions concerning externalities. If there are no externalities, the limiting rate of taxation on capital is zero, but if there exist increasing returns at the aggregate level, taxes should be much higher. Political economic theory suggests that political agents can work towards achieving the socially optimal rate. However, under a different set of assumptions, political agents can move the economy away from the optimal rate. In this paper, we test whether or not politics in the form of state-wide initiatives are employed by voters to move taxes towards the optimal rate. In this way, we can "score" the relevant models to determine which theory seems to be most supported by the data. We find initiatives are indeed employed to move the state economies closer to their optimal allocations.

JEL Classification: H1, H5, H8