Optimal Taxation and Public Goods

Abstract

In this article I construct a simple optimal income tax model in which I include a public good in the beliefthat it is a better approximation to reality than models that exclude it. The model comprises a Social Welfare Function (SWF), a government budget, and a constant elasticity of substitution utility function, whose arguments are: a private good, a public good, and leisure. The SWF can in principle be maximized with respect to the labor supply and to the amount of public good. My estimate of the optimal tax rate is higher and more realistic than are the predictions of models that do not allow for a public good. My results are consistent with the finding of empirical research, namely that the substitution parameter of the CES utility function is negative. Howew, the proposition derived from it (which forms the basis of recent work on income redistribution)—that the expenditure on public goods is regressive—has little significance, since it is the progressivity of the entire fiscal system that counts.