Tax Uniformity: A Commitment Device for Restraining Opportunistic Behavior

• Author: GERDA DEWIT,DERMOT LEAHY
• DOI: http://doi.org/10.1111/jpet.12104
• Date: 01 October 2015
• Published date: 01 October 2015

TAX UNIFORMITY:ACOMMITMENT DEVICE FOR

RESTRAINING OPPORTUNISTIC BEHAVIOR

GERDA DEWIT

National University of Ireland Maynooth

DERMOT LEAHY

National University of Ireland Maynooth

Abstract

We show that uniform and differentiated tax systems diverge

in their propensity to generate distortionary opportunistic

behavior. First, when firms choose investment before the

government can commit to its taxes, the tax scheme creates

strategic incentives for firms to distort their investment. Sec-

ond, a system of differentiated taxes has a greater propensity

to foster strategic distortions in investment than a uniform

tax regime. While the paper makes these points in a set-up

in which polluting firms face an emission tax and invest in

abatement, the main message is shown to hold for a wide

class of tax policy games.

1. Introduction

When policy makers try to regulate the behavior of economic agents, one

can expect those affected by the policy to behave opportunistically. The mod-

ern economic literature offers many examples of unanticipated responses to

Gerda Dewit, Department of Economics, Finance and Accounting, National University

of Ireland Maynooth, Maynooth, Ireland (Gerda.Dewit@nuim.ie). Dermot Leahy, Depart-

ment of Economics, Finance and Accounting, National University of Ireland Maynooth,

Maynooth, Ireland (Dermot.Leahy@nuim.ie).

We thank Søren Bo Nielsen, Rowena Pecchenino, Ian Wooton,participants of the Asso-

ciation of Public Economic Theory Conference in Istanbul (June 2010), seminar partici-

pants at the University of Strathclyde and National University of Ireland Maynooth, and

two anonymous referees for useful comments and suggestions. Dermot Leahy acknowl-

edges the support of the Science Foundation Ireland Research Frontiers Programme

(Grant MAT 017).

Received March 27, 2013; Accepted April 12, 2013.

C2013 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (5), 2015, pp. 641–672.

641

642 Journal of Public Economic Theory

policy activism and policy induced opportunistic behavior.1In fact, even the

pioneers of economics were aware of this phenomenon. Adam Smith (1790)

described the problem allegorically:

[The man of system] seems to imagine that he can arrange the dif-

ferent members of a great society with as much ease as the hand

arranges the different pieces upon a chess-board;... but..., in the

great chess-board of human society, every single piece has a princi-

ple of motion of its own, altogether different from that which the

legislator might choose to impress upon it.2

In this paper, we investigate whether and to what extent different tax

systems diverge in their propensity to encourage distortionary opportunis-

tic behavior. More specifically, we compare uniform and differentiated tax

regimes in terms of vulnerability to strategically manipulative behavior by the

firms that are targeted by the taxes. To our knowledge, this issue has hitherto

largely been neglected in spite of the fact that its policy implications are far

from trivial. Our analysis seeks to close this gap in the literature. We make

a case for tax uniformity as a policy commitment device for counteracting

firms’ opportunistic behavior.

The specific set-up in which we carry out our analysis features a forward-

looking,3benevolent welfare-maximizing government4that uses Pigovian

taxes to correct the behavior of polluting firms that create a negative

externality. We consider an individualized externality, implying that the iden-

tity of the firm causing the externality matters.5Hence, the government

may consider setting firm-specific taxes rather than a uniform emission tax.

1An example is given in Rodrik (1987).

2The Theory of Moral Sentiments, Part VI, Section 2, Chapter 2.

3In Rodrik (1987), the government is myopic rather than forward-looking. He argues that,

even when a policy is fully successful in correcting the distortion it was aimed at, it can

create a secondary distortion elsewhere. In his framework, the distortion arises because

the government is myopic in setting its policy.

4Our argument does not rely on an assumption that the government is subject to manip-

ulation by special interest groups. Instead, we abstract from political economy consider-

ations. In the political economy literature, the government typically does not maximize

a “pure” national welfare function because it is concerned with its political support. Pri-

vate sector agents then tend to engage in “directly unproductive” rent-seeking behavior

in order to manipulate governments (see, among many others, Bhagwati 1982, Grossman

and Helpman 1994; for a survey on the political economy literature, see Rodrik 1995).

An example of a paper that examines pollution abatement investment when firms lobby

against environmental regulation in a political economy set-up is Farzin and Zhao (2003).

Our model can, however, easily be extended to include political economy considerations,

as we discuss in Section 6.4.

5This terminology is adopted from Tresch (2008). A typical example of an individual-

ized externality is industrial air pollution since pollutants from different firms tend to af-

fect different groups of people, even if the firms’ emissions are identical: an air polluting

firm near a densely populated area is bound to create more damage than a firm located

in a relatively sparsely populated area. Global warming is, by contrast, an example of an

Tax Uniformity 643

The reasons why we choose to examine a system of differentiated emis-

sion taxes and compare it to a uniform one are twofold. First, even when

firms are de jure treated in the same way—that is, a uniform emission tax

applies to different firms—there tends to be scope for differential treat-

ment de facto—that is, different degrees of enforcement and verification

may apply (Van Long and Soubeyran 2001). The Third Assessment Report

by the Intergovernmental Panel on Climate Change (2003) states that, in

practice, most energy and emissions taxes apply differential tax rates to

different sources. In fact, almost all tax schemes involve reduced tax rates

or tax exemptions for industries that are energy intensive and/or export

oriented (B¨

ohringer 2002).6Second, a closer look at real-world emission

taxes also reveals that by no means all emission taxes are de jure uniform.7

These observations may help to explain why the discussion of differenti-

ated versus uniform taxes remains very much part of the current theoret-

ical literature8on the one hand and of the policy debate on the other

hand.9

In our framework, firms can invest in pollution abatement. We start

by showing that the existence of emission taxes creates strategic incentives

for firms to distort their abatement investment. The cause of the invest-

ment distortion lies in the fact that the government, as is often the case

in the real world, has commitment power in the short run but fails to

extend that commitment power to the longer run.10 Indeed, Laffont and

Tirole (1993) argue that even governments that have managed to acquire

a reputation of being “benevolent welfare maximizers” are often unable to

commit to policies in the longer run. The budgetary implications of their

policies tend to be reassessed regularly, often leading to a fine-tuning of

some of the previously adopted policies. Although governments can com-

mit to the general direction of policy in the long run by signing up to

international treaties, detailed policies including the setting of specific

aggregate externality. A framework involving international cooperation between govern-

ments would be a natural policy set-up in which to model aggregate externalities.

6This is mainly to maintain international competitiveness and sectoral employment in

these industries.

7For instance, sulphur emissions taxes are de jure differentiated in Italy (see report by

Environment Canada, Fuels Division, Oil, Gas and Energy Branch, 2003). Recently, three

Bills in Brazil propose a differential tax treatment for products and services based on CO2

emissions (Rodrigues 2011).

8Recent examples include Amir and Nannerup (2005), Honma (2005), and Lahiri and

Ono (2007).

9In a report prepared by Environment Canada, Fuels Division, Oil, Gas and Energy

Branch (2003), emission tax differentiation was specifically listed as one of the alternative

policy instruments to control sulphur emissions in Canada. Jiang and McKibbin (2003)

concludes in a simulation of alternative policy instruments that a differential emission tax

system is better for China than a uniform tax system (p. 226).

10 Lack of long-run commitment power by the government has been assumed in other

work (e.g., Petrakis and Xepapadeas 1999, Neary and Leahy 2000, Dewit and Leahy 2011).