Equity-efficiency dilemma and tax harmonization

Abstract The present paper attempts to demonstrate that finding an appropriate trade-off between direct and indirect taxes can help smooth policy makers’ way through reconciling the contradictory notions of equity and efficiency. Our theoretical and empirical analysis is based on the assumption that direct taxes discourage work effort, thus impinging on the incentives to supply labour, to save and to invest, and finally, to grow, whereas indirect taxes discourage consumption and bear more heavily on the poor. Central to our discussion is the argument that carefully designed adjustments in the tax mix can reduce distortions in the consumption-leisure decision, thus leading to an optimal allocation of resources between the equity and efficiency objectives. To derive a competitive equilibrium setting, a social welfare function is maximized and the first-order conditions are manipulated to trace out the optimal direct-indirect tax rates that pave the way for the equity-efficiency goals to be reconciled with each other.