Monday, 1 December 2014

The Ramsey Rule

I like to work things out for myself, so over the years I have come to the conclusion - moralising aside* - that the least-bad or indeed best kind of taxes are, in the following order:

1. Things where supply is completely unreponsive to price**, whether or not demand is price sensitive (i.e. land and other monopolies),

2. Things where both supply and demand are fairly unresponsive to prices (in particular oil and gas), and

3. Things where demand is particularly unresponsive to prices (addictive things like booze and smoking).

4. The worst kind of tax is one on things where both supply and demand are fairly price sensitive (pretty much everything else, i.e. exchanges of goods and services/labour in a free market).

See for example my post of three years ago. You don't need to have studied economics to work this out, you just look at the world as it is and observe.

* If you chuck morals into the equation, taxes on land and other monopoly rights shoot even further up the list and move from being least-bad to actually good taxes (from place 1 to -1), however the money is spent. The bansturbators argue that taxes on booze, smoking, gambling etc are inherently good taxes, being akin to fines or penalties, with nary a thought as to how the money would be spent. The other arguments for taxing fuel used for motoring are: environmental, depresses imports and crude road pricing.

** The Homeys argue, "Ah yes, but the government could easily increase the supply of desirable land by liberalising planning laws, building more transport links to those areas etc." For sure it could, but that does not increase the amount of land being supplied by any individual landowner, it merely benefits some individual landowners relative to others. LVT automatically claws back some of the benefits to some landowners and compensates the others.

It turns out that Frank P Ramsey formulated this ages ago, using rather convoluted language:

[the] consumption tax on each good should be "proportional to the sum of the reciprocals of its supply and demand elasticities".

So now we know.


Lola said...

You know that thing about Goebbels reaching for his Luger when he heard the word 'culture'? I have the same reaction when I see / hear 'social planner'..."that social planners should base optimal tax schedules...Grrrr.
But otherwise a great link that I shall study further.

Logan Boettcher said...

"Then he spelt out the implication (pp.56–7):

'If any one commodity is absolutely inelastic, either for supply or for demand, the whole of the revenue should be collected off it. This is independently obvious.... If there are several such commodities the whole revenue should be collected off them...'

He gave no examples. But, while there is no commodity for which the demand is absolutely inelastic, there is one obvious commodity for which the supply is absolutely inelastic, namely land — provided of course that the taxable criterion of “supply” is the existence of the land and not its allocation to any particular purpose."

Derek said...

I really liked the graphical illustrations in your 2011 posting. I think most people will find them easier to understand than Ramsey's paper.
But it's always nice to have mathematical backup from a Famous Economist.

Rich Tee said...

A couple of things on this subject:

1) I kept wondering why governments have recently been relaxing rules on gambling, and approving the building of "super casinos". Then I realised that it is a good source of tax income for them. It is easy to collect and they don't have to do anything to earn it, like build roads or hospitals.

2) I know that you disagree with this because some people do "VAT carousel" etc., but I understand that the reason politicians like VAT is because it is (theoretically) an easy tax to collect. There doesn't seem to be any other reason why they like it so much as it is a drag on the economy.

Mark Wadsworth said...

L, fair enough, you know what they mean.

LB, exactly, exactly. Was FR a land taxer who couched it in deliberately vague terms? Or was he a economics purist who knew he would be ignored anyway and so cared not what his tax would be applied to?

D, thanks and I hope so.

RT, re 1) probably, good point.

re 2) VAT is no easier to collect than other taxes, it all relies on honesty (the whole Google Apple Irish thing has as much to do with avoiding VAT as it does avoiding corporation tax).

The point is that VAT applies to the whole turnover and corporation tax applies to just a small part of it (the net profit).

So if a business can successfully hide one-tenth of its turnover, that only reduces the VAT base by one-tenth, but might wipe out the whole corporation tax base.

Lola said...

Not apropos of the thrust of MW piece, but the comments thread shows just how wonderful the WWW is. You can make a post like MW's and all sorts of people from all over the world turn up with additional and/or confirming insights which you can follow and learn even more.

Information is no longer the exclusive property of the privileged, And amen for that.

I may have mentioned that I have a dinner invite this week with the local Tory MP, so I am revising hard....this post has helped a lot.

DBC Reed said...

Economists tend to call taxes on bad things Pigouvian or Pigovian after Arthur Pigou (who was, despite the moniker, English)showing that they are Real Economists and not just people who know what they are talking about like Enoch Powell who studied Latin and Greek ( I ask you!)You have to call the bad things Negative Externalities to be part of the in crowd who didn't see the Credit Crunch coming and got put in their place by the Queen.You have to laugh!
However the great advantage of LVT is that it is the quintessential Pigou tax which prevents increases in the money supply from the banks setting off the negative externality of land price inflation instead of stimulating general demand as intended.Its scope is both macroeconomic in privileging investment in industrial capital over land;and it is historical in reversing a return to the early 19th century Political Economy when Conservatives defended Land Values against the Liberal
Manufacturing interest who wanted cheap food to starve their workers on and not to be made to pay excessive Income Tax.

Lola said...

DBCR. I really cannot follow any of that....

L fairfax said...


I agree with what you said.
Now assuming that you and I are not Geniuses (I know that I am not).
Why do you think so many politicians love VAT?

Shiney said...

@MW re @LFs question....

I'd like to know why as well.

Ben Jamin' said...


If you have think of LVT as a "tax" (which it isn't) a more perfect Pigouvian Tax you will not find.

But not for the reasons you mention.

Because of it's irreproducibility, exclusive use of land is the ultimate externality imposed on society.

LVT is how the market sets the compensation to be paid.

LVT=user fee. Not a tax.

Graeme said...

Ease of measurement should possibly come into the equation. How much of the tax code is taken up with definitions of income, wealth, capital gains, profit - there are even different definitions of income for NIC and income tax...Even VAT, which ought to be easy, is full of bizarre and non-intuitive stuff about where the transaction was made and which transactions are Vatable or exempt or outside the scope, or whatmakes something a biscuit rather than a cake, or how to tax bags of nuts and raisins. A good tax should be definable in less than 300 close-typed pages.

Ben Jamin' said...


Rare artifacts are inelastic.

Art, cars, antiques etc, etc.

Should these also be subject to high(or any) taxation?

I say no.

That is because the utility and value of all these things can be reproduced.

In reality art, cars, furniture are all elastic in supply.

I could, in theory produce the most valuable piece of artwork/car/furniture in the World myself.

No one is therefore being deprived.

Which is the crucial difference between land and capital.

Mark Wadsworth said...

LF, S, see separate post on VAT.

G, agreed to all that.

"A good tax should be definable in less than 300 close-typed pages."

The whole legislation for council tax and business rates is a few paragraphs, barely 300 words let alone 300 pages.

BJ, that's a KLN "You're saying we should tax land because supply is inelastic, well what about antiques?" I've heard it many a time.

Antiques aren't land, they are, as you say, capital.

Further, even if you wanted to tax them it fails for practicality and the small sums you'd raise would not be worth the effort.

In any event, Ramsey referred to taxes on "commodities" so he must mean things that are being produced or supplied in the present. Antiques aren't really "commodities'.