Good Tags, Bad Tags

Abstract

In the literature on optimal taxation, a “tag” is a government-observable taxpayer attribute that is effectively immutable – like blindness, race, gender, or even height. Conventional optimal tax theory prescribes that tags should be included in the tax base so long as they are in some way correlated with “ability” or “endowment” (more precisely, with “social welfare weight”: the marginal social welfare of transferring resources to the taxpayer). Such correlation is a weak requirement. And it has recently been pointed out that the list of seemingly absurd taxes and subsidies that are thereby deemed optimal poses a challenge to the basic framework of optimal tax theory in the form of a reductio ad absurdum. This paper attempts to draw a principled distinction between two ideal types of tags – those that are directly welfare-relevant and those that are welfare-relevant only when and if they are taxed or subsidized, and only through such taxation or subsidy. A stark distinction arises between these types when the optimal tax model is extended to include the realism-enhancing feature that the government is uncertain regarding the association in the population of taxpayers between the incidence of the tag and social welfare weight. It is shown that such uncertainty generally decreases the impetus for taxation or subsidy when the attribute is non-welfare relevant, but not when it is directly welfare-relevant.