Putting Firms into Optimal Tax Theory

Firms are, for the most part, absent from the modern theory of optimal taxation. Their disappearance dates from the foundational models developed by Peter A. Diamond and James A. Mirrlees (1971) in which firms are simply mechanical vehicles for combining productive inputs into output in cost-minimizing proportions. i In contrast, firms play a central role in all modern tax systems, mostly for a reason eloquently stated by Richard M. Bird (1996): “The key to effective taxation is information, and the key to information in the modern economy is the corporation. ” In most countries, firms remit the majority of tax revenues to the government, either with regard to taxes legally owed by businesses or through withholding of taxes legally owed by employees or other businesses. ii Even when businesses are not required to remit taxes, they are often required to file information reports that can facilitate monitoring of tax liabilities. The lack of a theoretical framework that features firms handcuffs rigorous welfare analysis of a number of important policy issues. One such example is the comparative evaluation of a uniform retail sales tax (RST) versus a value-added tax (VAT). In the standard model, these two taxes—both remitted entirely by businesses—are equivalent consumption