Tax Policy Design in the Presence of Social Preferences: Some Experimental Evidence

Article excerpt

Abstract: This paper reports the results of experiments designed to examine whether a taste for fairness affects people's preferred tax structure. Building on the Fehr and Schmidt (1999) model, we devise a simple test for the presence of social preferences in voting for alternative tax structures. The experimental results show that individuals demonstrate concern for their own payoff and inequality aversion in choosing among alternative tax structures. However, concern for redistribution decreases when it leads to increasing deadweight losses. Our findings have important implications for the design of optimal tax theory.

JEL classification: C92, 1)63, H21, H23.

Key words: tax policy, social preferences, fairness

There is a belief among some public finance economists--especially among its practitioners--that, if enacted, optimal tax policy prescriptions would be widely unpopular with the public. Therefore such policies are often regarded as politically infeasible though theoretically optimal. (1) Such conclusions are puzzling. After all optimal tax policy prescriptions are derived from the maximization of a social welfare function of individual utilities subject to a tax revenue constraint [see, for example, Ramsey (1927), Min-lees (1971), Diamond and Min-lees (1971), and McCaffery and Slemrod (2004)]. If individual utility is correctly specified and the social welfare function properly accounts for distributional concerns then optimal tax policy prescriptions should be popular with the public rather than unpopular. (2)

One possible explanation for this paradox may be that individual utility is not correctly specified as depending exclusively on one's own payoff. Rather people may care about their own payoff as well as the payoffs of others, i.e., people have social preferences. Outside the context of optimal tax theory, the existence of social preferences is well established [see, for example, Frohlich and Oppenheimer (1992), Ledyard (1995), Camerer (1997), Bolton and Ockenfels (2000), and Charness and Rabin (2002)]. Clearly the policy prescriptions of optimal tax theory may be quite different if people care not only about their own payoff but also the payoffs of others. (3) More specifically, if people care about the distributional consequences of taxation, then tax structures that are perceived to result in an unfair distribution of after-tax incomes will reduce individual utility relative to tax structures that better satisfy individual concerns for distributional equity. (4) That is, the loss in utility associated with an unfair distribution of incomes may be just as keenly felt as the conventional excess burdens of distortionary taxation. (5)

The most direct evidence bearing on this issue comes from the path breaking work of Frohlich and Oppenheimer (1992) and Engelmann and Strobel (2004). Frohlich and Oppenheimer (F&O) use laboratory experiments to investigate which principle of distributive justice people choose absent knowledge of their position in the income distribution. (6) In other words, they ask subjects to express a preference for a principle of distributive justice among several stylized principles, such as the familiar maximin principle [Rawls (1971)], efficiency principle [Harsanyi (1953, 1955)], among others. (7) F&O find that most groups choose a mixed principle: they prefer to maximize average income as in Harsanyi constrained by an income floor for the worst-off individual as in Rawls. Although F&O do not directly address the choice of tax structure, their results can be interpreted to imply that people care about both the efficiency and distributional consequences of tax policy and not, as in conventional optimal tax theory, simply the size of their own after-tax payoff. Though very instructive, their experiments do not provide quantitative evidence on the nature of the trade offs among the potentially conflicting goals of maximizing one's own payoff, maximizing the sum of individual payoffs, and maximizing the payoff of the worst off individual. …