The Effect of Optimal Rates of Indirect Tax on Social Welfare in Iran

Tax reform as a part of financial system’s reforms constitutes the core of fiscal policies and economic adjustment process. The widening tax base and rationalizing tax rates are main priorities in this regard. This paper aims to calculate optimal commodity tax rates and marginal cost of social welfare resulting from indirect taxes in Iran. The calculation of marginal cost of social welfare requires determining the own and cross price elasticities of demand and optimal tax rates for goods and services. These parameters are obtained by estimating demand function of ten good and service groups in a linear expenditure system. This system is estimated through seemingly unrelated regression method using data of ten expenditure deciles of urban households in Iran during 1996-2010. The optimal tax rates are calculated using Ramsey method in a multi-person world and Bergson-Samuelson's social welfare function. In this model, a social welfare function is maximized with respect to given tax revenue of government using Lagrange method. Results show that when social inequality aversion parameter is zero, optimal tax rates almost are equal. By increasing this parameter, which fairness rather than efficiency is considered, these rates are diverged, in a way that some commodity groups are entitled to get subsidy. In addition, as social inequality evasion parameter increases, the marginal cost of social welfare resulting from change in commodity tax rates decreases, and welfare loss gets very small in the highest social inequality evasion rate. So, decreasing subsidy among all good and service groups receiving subsidy, and increasing tax on other groups lead to decrease in social welfare.