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Work on optimal commodity taxes by Professor of Economics Peter A. Diamond was mentioned in the citation for the Nobel Prize for Economics, awarded Tuesday to University of Cambridge Professor James A. Mirrlees and Columbia University Professor William Vickrey for their contributions to the economic theory of incentives in situations where decision-makers have differing information.
Professor Mirrlees, 60, who has done major work on optimal income taxes, was a visiting professor at MIT who worked with Professor Diamond in the fall of 1994.
The Nobel Prize citation commented, "Mirrlees has made several far-reaching contributions in public economics, particularly in optimal taxation and development. One of his most important contributions in public economics, carried out jointly with Peter Diamond, consists of a very thorough and almost definitive treatment of optimal commodity taxes."
Mirrlees's work on optimal income taxes developed a methodology "which has become a paradigm in the economics of asymmetric information," the Royal Swedish Academy of Sciences said in its release, available on the Web at
The Academy, citing other contributions by Dr. Mirrlees, wrote as follows:
"In collaboration with Peter Diamond, Mirrlees has also carried out a comprehensive analysis of commodity taxes in a second-best world. Due to the fact that commodity taxes create a `tax wedge' between consumer and producer prices, taxpayers are prepared to pay more in order to avoid the taxes than the amount which accrues to the government in tax revenue. Given that this social cost cannot be fully prevented, taxes have to be chosen in the second-best way.
"The general theory of optimal taxation in a second-best economy encompasses few clear-cut recommendations. If one condition for social efficiency is violated, as a rule there is reason to violate others as well. However, Diamond and Mirrlees (1971) obtained a highly universal result. Under relatively general conditions, it is desirable to maintain production efficiency. In concrete terms, this means that taxes should not be levied on factors of production.
"The underlying intuition is relatively simple. Assume that final consumption varies continuously with tax rates. Diamond and Mirrlees showed that, in general, there exists a change in the tax rates which is advantageous to all consumers. If production is not efficient at the outset, i.e., it is in the interior of the production set, there will be a sufficiently small change in tax rates which is favorable to all consumers and still keeps the economy within the production set (due to continuity). Hence, the initial situation could not have been optimal.
"As already indicated, this result has had widespread consequences for project appraisal and economic policy in developing countries. On a theoretical level, the analysis has been generalized in various directions in Mirrlees (1972) and Diamond and Mirrlees (1976)," the Nobel citation said.
A version of this article appeared in MIT Tech Talk on October 9, 1996.