Production efficiency and constraints on profit taxation and profit distribution in economies with Ramsey taxation

Abstract

In economies with Ramsey taxation, decreasing returns to scale, and private ownership, we show that second-best production efficiency is desirable when the grouping of private firms induced by the profit taxation power of the government is at least as fine as the grouping of firms induced by the institutional rules of profit distribution in the economy. The classic results of Dasgupta and Stiglitz [1972] (of firm-specific profit taxation) and Diamond and Mirrlees [1971] and Guesnerie [1995] (of uniform one-hundred percent profit taxation) follow as special cases of our model. Moreover, second-best analysis shows that optimal profit taxation is a substitute for optimal intermediate input taxation. In smooth economies, proportional, lump-sum, and affine modes of profit taxation are equivalent. We rework Mirrlees [1972] counterexample, which is posed in the context of a non-smooth economy, to show that second-best production efficiency continues to remain desirable under an affine structure of profit taxation.