Optimal taxation is the taxation that reflects society’s choices between the rival goals of equality and economic efficiency, the starting point of which is to maximize social welfare.
The theory of optimal taxation has tended to recast the existing literature of public finance into the mould of classical welfare economics by emphasising minimisation of dead weight losses resulting from the imposition of a tax or faulty tax structure.
The ideal, or optimal, rate of taxation for an economy is the one that falls right at the top of the inverted-U. The theory argues if tax rates are too high they will discourage taxed activities, like consumption and investment, while rates that are too low fail to generate sufficient revenue.
For example, giving $100 is worth more to a low-income earner than to a high-income earner.
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