Four Principles of Optimal Tax System Design
Theodore P. Seto
Loyola Law School Los Angeles
March 24, 2013
Loyola-LA Legal Studies Paper No. 2008-36
Although optimal tax theory dominates both tax economics and tax law scholarship in the upper academic ranks, legal academics make remarkably little use of it in their day-to-day work. This is unfortunate. Although I am unwilling to accord efficiency the primacy that optimal tax theory gives it, the behaviorally distortive effects of tax rules should be of concern regardless of one’s normative perspective. Distortive effects are not merely inefficient; they affect fairness and administrability as well. We know, for example, that if the relevant supply or demand curve of a nominal taxpayer is elastic, she is unlikely to bear the ultimate burden of a tax or rule. If so, the burden of a tax or rule that is supposed to be borne by one group may in fact be shifted to another. Tax shelters and the administrative problems they create similarly cannot be understood without taking into account the behaviorally distortive effects of the rules on which they rely.
The paper proposes four nonmathematical principles that, consistently applied, should result in rules that minimize such distortion:
1. Tax liability should not turn on factors as to which taxpayer is relatively indifferent (“relative indifference”).
2. The least distortive tax base for any taxpayer is whatever that taxpayer would seek to maximize in the absence of taxation (“taxing the maximand”).
3. If what taxpayer would seek to maximize in the absence of taxation is a number already computed for non-tax purposes, tax administrative costs will be minimized if the tax base equals that reported number (“taxing the reported maximand”).
4. Taxpayers should be classified for tax purposes by reference to whatever it is they would seek to maximize in the absence of taxation (“classification by maximand”).
All else being equal, rules consistent with these four principles are more likely to be efficient, more likely to effect intended distributive goals, and less likely to invite tax avoidance than rules that are not.
The paper then illustrates the power of these principles by applying them to a problem that has long resisted solution: design of a minimally distortive system for taxing corporations, particularly multinational groups. Such a minimally distortive system, it concludes, would tax all publicly-reporting corporate groups, domestic and foreign alike, on their adjusted book income, computed on a consolidated basis and allocated among jurisdictions using a single factor formula based on sales adjusted by industry-average profit-to-sales ratios.
Number of Pages in PDF File: 40
JEL Classification: F23, H21, H26
Date posted: November 19, 2008 ; Last revised: March 25, 2013