HLS Faculty Scholarship

Optimal policy rules—including those regarding income taxation, commodity taxation, public goods, and externalities—are typically derived in models with homogeneous preferences. This article reconsiders many central results for the case in which preferences for commodities, public goods, and externalities are heterogeneous. When preference differences are observable, standard second-best results in basic settings are unaffected, except those for the optimal income tax. Optimal levels of income taxation may be higher, the same, or lower on types who derive more utility from various goods, depending on the nature of preference differences and the concavity of the social welfare function. When preference differences are unobservable, all policy rules may change. The determinants of even the direction of optimal rule adjustments are many and subtle.

In my original paper, I demonstrated that, under standard simplifying assumptions, it is possible to finance a public good in a manner such that a Pareto improvement results whenever the simple cost-benefit test is satisfied—that is, without any adjustment for the “marginal cost of funds.” In particular, the method of finance involves adjusting the income tax so that the combined incidence of the tax adjustment and the public good is distribution neutral. One implication of this result is that, if the public good is financed in some other manner, the difference in outcome will be purely redistributive, so that any change in distortionary costs will be accompanied by an opposing change in redistributive benefits. I also showed how this analysis is applicable to determining the optimal level of environmental taxes. Browning and Liu’s comment does not disagree with any of these claims. Instead, their argument focuses on how one should interpret the term “distortion.” It should not be surprising, however, that under any interpretation of the term— including their preferred one—my conclusions about how policy analysis should be conducted continue to be correct.

Shifting victorious plaintiffs' fees to defendants and increasing damage awards are alternative ways to achieve similar results: increasing plaintiffs' incentives to sue and raising defendants' expected payments. This article shows that relying on higher damage awards is more efficient than shifting plaintiffs' fees. The reason is that fee shifting is more valuable for plaintiffs with higher litigation costs. Thus, it is possible to substitute higher damage awards for fee shifting in a manner that leaves deterrence unaffected while eliminating the suits of plaintiffs with the highest litigation costs.

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The federal income tax allows deductions for some categories of personal losses, notably for casualty losses (such as destruction of one's home or car) and medical expenses above a threshold. The latter, even with lower marginal rates and further restrictions brought about by the 1986 tax reform, involves more than $3 billion annual revenue loss (Office of Management and Budget, 1990).(1) Deductions like these act as partial insurance: individuals receive a tax benefit equal to their marginal rate multiplied by the magnitude of their loss. However, this form of insurance is unnecessary when private insurance is available. Moreover, as will be emphasized here, these deductions have a perverse effect because they are allowed only for the uninsured portion of losses. This induces individuals to be less protected against risk in the aggregate than if the implicit insurance provided by the tax system were unavailable; if the tax rate is sufficiently high, individuals would forgo insurance coverage altogether.(2) It will be demonstrated that a tax system with no deductions for personal losses Pareto dominates the current system. These conclusions are demonstrated in Section I using a simple model in which risk-averse individuals may purchase actuarially fair insurance against loss and individual behavior does no affect the risk and loss (no moral hazard). Section II considers the applicability of the results when one allows for moral hazard, administrative costs, and other imperfections. It also discusses the applicability of traditional notions of tax equity.

Whether personal income tax deductions are appropriate refinements to the concept of income or are unwarranted tax expenditures continues to be the subject of debate. The casualty loss and medical expense deductions are frequently justified on the ground that largely unavoidable losses or expenditures reduce one's ability to pay taxes. This Article reconsiders the question, taking into account the availability of private insurance, which is widespread for relevant losses in both areas. The author argues that when individuals can insure, the second level of insurance implicit in the casualty loss and medical expense deductions has undesirable effects on consumption choices and insurance decisions. In particular, individuals may be more exposed to losses because of tax deductions commonly believed to mitigate them. He concludes that, given the option, individuals would prefer a regime that eliminated the deductions and offered correspondingly lower tax rates.

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In Fairness versus Welfare, we advance the thesis that social policies should be assessed entirely on the basis of their effects on individuals’ well‐being. This thesis implies that no independent weight should be accorded to notions of fairness (other than many purely distributive notions). We support our thesis in three ways: by demonstrating how notions of fairness perversely reduce welfare, indeed, sometimes everyone’s well‐being; by revealing numerous other deficiencies in the notions, including their lack of sound rationales; and by providing an account of notions of fairness that explains their intuitive appeal in a manner that reinforces the conclusion that they should not be treated as independent principles in policy assessment. In this essay, we discuss these three themes and comment on issues raised by Richard Craswell, Lewis Kornhauser, and Jeremy Waldron.