Question

In the design of an optimal tax system, explain why the inefficiency caused by a tax relates to the substitution effect of the tax and not the income effect. What relevance do income effects have in effecting the nature of optimal taxes?

Answer 1

Optimal tax theory or the theory of optimal taxation is the investigation of planning and actualizing an expense that lessens wastefulness and twisting in the market under given monetary limitations. For the most part, this measure comprises of people's utility and the improvement issue includes limiting the twists caused by tax assessment. A nonpartisan duty is a hypothetical expense which keeps away from contortion and wastefulness totally. Different things being equivalent, if a citizen must pick between two totally unrelated financial undertakings (say ventures) that have the same pre-charge hazard and returns, the one with the lower assess or with an expense exclusion would be picked by a reasonable on-screen character. Subsequently business analysts contend that charges by and large mutilate conduct.