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While I was studying eighth edition of Mankiw's Macroeconomics, in chapter 9 on Economic Growth(pg. 245), the author mentions :

"Some economists have proposed increasing the incentive to save by replacing the current system of income taxation with a system of consumption taxation."

Here, the book was discussing on the topic of government policies that affect rate of saving and spur growth. My question is that doesn't this finding contradicts with Second Welfare Theorem in Microeconomics, according to which, the taxation should be on endowments and not on consumption goods so that we can have Pareto Efficient allocation(refer Varian's Intermediate Microeconomics eighth edition Ch. 31, pg 605)? Or am I wrong in superimposing the micro concept over macro?

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  • $\begingroup$ I don't have that book at hand: does Varian mean Pareto efficient as in total consumption, or does he refer to the efficient allocation within different consumption goods? $\endgroup$ – FooBar Apr 20 '15 at 12:06
  • $\begingroup$ Varian discussed the simultaneous equilibrium of different goods market through Walras' Law and reached to the implications of Second Welfare Theorem, where he mentioned two roles of prices in the market system-allocative and distributive. So, in order to get equal distribution and Pareto efficient allocation, he implied that there is no problem in distributing the endowments but when we tax consumption inefficiency arises. $\endgroup$ – Dhruv Goel Apr 20 '15 at 19:10
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The two statement say two completely different things. So, no, there is no contradiction.

The second welfare theorem essentially says that a system of transfers that results in an efficient allocation can be supported by a competitive outcome. The statement about replacing income taxes with a consumption tax will increase peoples' incentives to save. These are two completely different statements.

Your mistake is that you suppose that the second welfare theorem prescribes a system of taxation to achieve the hypothetical transfers. It doesn't. The second welfare theorem just supposes that these transfers can be made---nothing more. Importantly, the alleged social planner who makes the transfers has complete information about the agents in the model. When information about the agents is hidden from the social planner (information such as the skills and true abilities of each individual), such transfers become difficult and costly. That is, they create distortions. This was a point that was famously made by James Mirrlees in his seminal paper "An Exploration in the Theory of Optimum Income Taxation" (1971). The point of this paper is that there is a trade-off between equity and efficiency. Once we consider the fact that transfers are costly and create distortions, the question is, how do we create a tax system that minimizes the amount of distortions and still is able to make desired transfers of wealth. This serves as a motivation for why people might study the incentives created by an income tax or consumption tax, for example.

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  • $\begingroup$ Thanks, it cleared my doubt. Also can we say that Micro concepts are more idealistic as compared to Macro, and such superimposition of Micro over Macro is normally not possible? $\endgroup$ – Dhruv Goel Apr 22 '15 at 3:28
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    $\begingroup$ @DhruvGoel The fundamental welfare theorems are often taught in macro classes as well as micro classes. Furthermore, a lot of research in macro in the last few decades has focused on the microeconomic foundations of macroeconomics. So, yes, they go together. $\endgroup$ – jmbejara Apr 24 '15 at 4:18
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This does not contradict welfare theorems (1st or 2nd), because income tax is a distortionary tax just like consumption taxes. Income tax is a subsidy on the consumption of leisure.

Endowment tax would be a lump-sum tax for each person independent of the person's choices, among others the choice of how much to work, what qualifications to obtain etc. These lump-sum taxes are politically impossible to impose. So discussion of real-life tax issues is partly about which tax is the least distortionary or creates good incentives (distortions in the right direction). Your quote is part of this discussion.

You are not in general wrong in applying a micro concept to macro.

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