Monday 19 October 2009

Hoisted from the comments: Ramsey pricing and alcohol

Seamus reminds us that Ramsey pricing does not necessarily recommend taxing inelastic goods; rather, it recommends, because of the existence of untaxed leisure, that optimal taxes will vary with goods' cross-price elasticity with leisure. Goods complementary to leisure draw a higher optimal tax than goods complementary to labour. Seamus's interpretation of Ramsey follows, I belive, Corlett and Hague's classic rendition.

The Tax Working Group's paper on "Other Base Broadening Ideas" takes an alternative interpretation of Ramsey
Ramsey taxation

The Ramsey theory of taxation recommends higher tax rates on goods with the most inelastic demand as a means of raising revenue in the most efficient way possible. This is based on the assumption that taxes on goods with inelastic consumer demand would have small distortions relative to goods with more elastic consumer demand, and therefore lower dead weight costs.

The McLeod review found that in the New Zealand context, where tobacco and beer are thought to have the most inelastic tax bases, while the demand for wine and spirits are more elastic, it was not possible to justify the then levels of excises and duties on Ramsey taxation grounds.
Note that "not possible to justify" means "the excise tax should be cut substantially or eliminated", not "too low".

The Tax Working Group uses the standard undergrad textbook formulation of the Ramsey Rule (see Hindriks and Myles, for example). The result holds under assumptions of infinite supply elasticity (because otherwise deadweight losses to consumers are only part of the welfare effects); if there are cross-price effects between taxed goods, things also get much more complicated - Ramsey then doesn't reduce to the inverse-elasticity rule. And if there are cross-price effects between taxed goods and leisure, then we get the Corlett and Hague result.

So, is alcohol a greater complement to leisure than are other goods, and in particular is it a greater complement to leisure than to labour? Tough call. Lots of business lunches are facilitated by alcohol, and there is decent evidence that drinkers earn more than never-drinkers, partially due to complementarity between drinking and business activity. But neither forms of the Ramsey rule particularly suggest increasing the alcohol excise tax, and the McLeod review firmly opposed it.

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