**5. Redistribution and Ramsey taxes**

Under the assumption that people resemble each other, Ramsey taxes are expressed as the

In the inverse elasticity rule suggested by Ramsey, under the assumption that supply curve is finite or, in other words, a horizontal supply curve exists, tax is stated to be inversely proportional to compensated demand elasticity. Accordingly, all goods to be affected equally from taxes are aimed by collecting lower rates of taxes from goods with high price elasticity

Within the framework of this purpose, Sandmo [19] expresses that Ramsey rule can be based

(i) Being able to minimize efficiency loss, which occurs as a result of distortionary taxation, is possible through tax applications with a low substitution effect. Because of this reason, goods with prices that do not create substitution effect are the ideal subject of the tax. In other words, in cases where lump-sum taxes cannot be imposed, commodity taxes with

(ii) Goods, which will be taxed at high rates, should have a high leisure complementary

Elasticity of substitution between goods and leisure lies behind the fact that single rate tax, which does not change the relative prices of goods and will not be different from the lump-

*<sup>d</sup>* + 1/*ns*

represents supply elasticity [9].

) (1)

*d*

represents com-

*<sup>p</sup>* = k (1/*nu*

of demand and higher rates of taxes from goods with low price elasticity of demand.

In this equation, *t* represents tax rate per unit, *p* represents price after tax, *nu*

sum of the inverses of supply and demand elasticity.

\_\_*<sup>t</sup>*

**Figure 1.** Deadweight loss of taxation. Source: Ref. [44].

128 Taxes and Taxation Trends

pensated elasticity of demand, and *n<sup>s</sup>*

on the following three hypotheses:

level.

similar effects should be imposed.

sum tax that will be imposed on labor income, is not optimal [14].

Ramsey taxes, which were pointed out in the above section in detail, are criticized because of its current assumptions and negativity they might create in income distribution.

At this point, first main criticism to Ramsey analysis is the assumption that all individuals resemble each other. The fundamental reason for the state to use distortionary taxes instead of lump-sum taxes is to have redistribution goals, which are not possible to attain in another way. In case this assumption is valid, there are no causes of the state for not imposing lumpsum taxes.

Nevertheless, when taxes are imposed within the context of inverse elasticity rule, an equal amount of decrease in demand in all goods will be caused by collecting lower rates of taxes from goods with a high possibility of change in demand amount and at higher rates from goods with a low possibility of change in demand amount; and thus, efficiency loss will be minimized. According to this approach, taxation of necessity goods, which have low compensated demand elasticity and have a large share in the consumer's budget, at a higher rate than luxury goods comes to the fore [9].

Generally, price elasticity of demand for good, which are consumed with the purpose of meeting basic needs, is low, while price elasticity of demand for luxury goods is high. Based on this rule, tax rate to be imposed on basic necessity goods will be high, and tax rate to be imposed on luxury goods will be low. What needs attention here is the assumption that consumers are alike. However, since income distribution and demand for different products will vary, such a rule will create negative results in terms of tax equity especially in developing countries.

Ramsey defended this rule by placing economic efficiency to forefront. Therefore, although theoretically consistent, this analysis becomes contradictive in practice with the influence of socio-political reasons [20].

In short, when Ramsey's suggestion is applied, low-incomers, who relatively allocate majority of their income to necessity goods, have to face a high tax burden. Therefore, a conflict between the goals of decreasing the efficiency cost of tax and equitable tax emerges. Ramsey rule puts forward what needs to be done when efficiency purpose is desired to be pursued. Goal of justice is not within this rule's field of interest [18].

As a result in optimal commodity taxation, Ramsey's analysis requires a careful analysis of: the constraints on taxation; the elasticities of demand and supply; and the structure of the economy [21].
