On the Definition of Tax Neutrality: Distributional and Welfare Implications of Policy Alternatives

Abstract

The fairness of a tax change is often judged by examining its impact on tax burdens or net incomes of different income classes. Two competing definitions of tax neutrality give surprisingly different and conflicting answers to the fairness question. If the objective is to maximize welfare, the Lorenz dominance principle offers guidance as to how tax neutrality should be defined. In the presence of asymmetric information the different definitions of tax neutrality make it possible for politicians to adopt the definition that favors their constituency and/or serves a particular political agenda. The median voter model is applied to explore the definition of neutrality in a democracy. In general, decisions by rational self-interested voters and politicians may, but do not necessarily, result in the definition that leads to Lorenz dominance.