Public Finance, 3rd Edition

First-Best Theory, Second-Best Theory, and Tax Incidence

We have delayed discussing the general theory of tax incidence until this part of the chapter, since the most interesting questions in tax incidence are inherently second best in nature, precisely because they depend on the market's response to distorting taxation. In first-best theory, all questions of distributional equity are incorporated into the interpersonal equity conditions,

∂W∂Uh∂Uh∂Ih=∂W∂Uj∂Uj∂Ijallh,j=1,…,H

(16.1)

which the government satisfies through a set of lump-sum taxes and transfers among the consumers. As a general rule, these lump-sum redistributions affect equilibrium market ...