A Comparative Mathematical Study of the Relationship Between Marginal Social Cost and Pigouvian Tax in the Presence of Commodity and Wage Taxes: Putting Ramsey Theorem into Practice

Abstract

The aim of this paper is to examine the relationship between the Pigouvian tax and marginal social cost in the presence of distortionary taxes such as commodity and wage taxes in a Ramsey setting. The Ramsey theory highlights the amount of tax required to raise a given revenue for the government which also maximizes household utility. Previous research in this regard has been carried out either under homogeneous household preferences or a constant marginal social cost. In this paper we go further by analyzing the relationship between Pigouvian tax and marginal social cost in the presence of commodity taxes when households have heterogeneous preferences as opposed to being assumed homogeneous. In addition, we also consider the relationship between Pigouvian tax and marginal social cost in the presence of wage tax when the marginal social cost is considered as a variable depending on Pigouvian tax as opposed to being considered a constant in previous literature. The results indicate that the Pigouvian tax in the presence of wage tax is higher when the marginal social cost was considered a variable as opposed to a constant. Under certain conditions, in the presence of commodity taxes it was observed that the value of the Pigouvian tax is higher when households have heterogeneous preferences as opposed to homogeneous preferences. The mathematical models used in this study enable to see the factors, such as homogeneity/heterogeneity of household preferences and marginal social cost assumed as a variable as opposed to a constant, that impact the dynamics in determining the optimal Pigouvian tax.

Keywords: Distortionary tax, Ramsey theory, Pigou tax, Marginal social cost, Lagrange multiplier