Holcombe RamseyReconsidered PFR2002

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Finance Review
The Ramsey Rule Reconsidered

Randall G. Holcombe
Public Finance Review 2002 30: 562
DOI: 10.1177/109114202238003
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PUBLIC
Holcombe
FINANCE
/ THE
REVIEW
RAMSEY RULE RECONSIDERED
The Ramsey rule for optimal excise taxation suggests that goods should be taxed in inverse proportion to their elasticities of demand. This analysis shows that when the political process that determines tax rates is taken into account, the Ramsey rule may not be
superior to a fiscal constitution that specifies that all goods are taxed at the same rate.
The information necessary to set taxes in conformance with the Ramsey rule is not directly observable, which will lead to rent-seeking activities as interest groups try to influence the political determination of tax rates they face. Furthermore, incentives in the political process work against setting taxes according to the Ramsey rule. Building on
Buchanans work on optimal taxation and the nature of the fiscal constitution, the
Ramsey rule should be reconsidered as a guide to optimal excise tax policy.
THE RAMSEY RULE RECONSIDERED

RANDALL G. HOLCOMBE
Florida State University
One of the most enduring and least questioned concepts of optimal

taxation is the Ramsey rule, which states that under certain assumptions, the excess burden of excise taxes is minimized when goods are
taxed in inverse proportion to their elasticities of demand.1 As a principle of tax policy, the Ramsey rule does not consider the political environment within which taxes are designed. Once that environment is
explicitly taken into account, the Ramsey rule comes up short as a
principle of tax policy for two related reasons: (1) Decision makers
who design taxes do not have sufficient information to create a tax
structure that conforms to the Ramsey rule, even if they want to, and
(2) if policy makers nominally try to implement the Ramsey rule, the
incentives inherent in the political process will lead to nonoptimal
taxes and will result in a substantial amount of rent-seeking losses
while doing so.
After discussing the problems with using the Ramsey rule as a
guide to public policy decisions on excise taxation, this article considers the public finance paradigm within which the Ramsey rule has become generally accepted and considers the implications for optimal
taxation more generally. This line of reasoning supports Buchanans
PUBLIC FINANCE REVIEW, Vol. 30 No. 6, November 2002 562-578
DOI: 10.1177/109114202238003
2002 Sage Publications
562
Holcombe / THE RAMSEY RULE RECONSIDERED
563
(1967, 1975, 1976) idea that the tax structure should be embodied in a
relatively inflexible fiscal constitution, and such a fiscal constitution
would have no room for concepts like the Ramsey rule, which imply
flexibility in tax policy.
THE INFORMATIONAL REQUIREMENTS

OF THE RAMSEY RULE
Because in its simplest form, the Ramsey rule advocates setting excise tax rates for goods in inverse proportion to their elasticities of demand, if a legislature wants to apply the Ramsey rule, at a minimum it
would have to know the demand elasticities of the taxed goods. Herein
lies the first problem. Demand elasticities are not directly observable.
The market directly generates price data, so if a legislature wanted to
know the prices of goods, it could observe them directly; however, to
find the demand elasticities of goods, it would have to somehow obtain estimates. In a democratic government, the process of obtaining
such information is a political process in which interest groups involve
themselves to try to generate outcomes that favor those groups. Each
interest group has an incentive to hire experts who provide the legislature with information showing that their goods have very elastic demands and so should have low taxes, whereas the goods of other sellers are very inelastic. Other interests do the same, so the legislature
will be presented with conflicting information from interest groups
that are trying to minimize their own tax burdens. Because there is no
way to directly observe the information the legislature needs to implement the Ramsey rule, the demand elasticities it uses are more likely to
reflect the political strengths of various interest groups than the actual
elasticities of demand for the taxed goods. One might argue, following
Becker (1983) and Wittman (1989), that the political process will generate accurate information about demand elasticities, but the model
presented below casts doubt on this idea.
Before public choice, public finance typically assumed that public
policy was made by an omniscient and benevolent government that always implemented policy according to the welfare-maximizing policy of the economic model being employed. If the assumption of be-
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PUBLIC FINANCE REVIEW
nevolence is retained, but the assumption of omniscience is dropped,

those in government do not have sufficient information to implement
the Ramsey rule even if they wanted to. Implementation requires that
those in government know the elasticities of demand of taxed goods,
but this information is not observable.
FLEXIBLE TAX RATES AND

INTEREST GROUP POLITICS
The information problem is worse than the previous section indicates because the Ramsey rule is derived in a static model, but in the
real world, demand elasticities change over time. Implementing the
Ramsey rule is not simply a matter of estimating demand elasticities
and setting tax rates in inverse proportion to them in perpetuity. If the
excise tax structure is designed to minimize the excess burden of taxation, excise tax rates must continually be adjusted to reflect changes in
the underlying economic data. This further opens the process to political manipulation. Interest groups cannot simply present their best
cases and then pay whatever taxes the political system throws their
way. Rather, there is the continuing incentive for interest groups to go
back to the legislature to argue that demand for their goods is more
elastic now than it was when the tax structure was last adjusted, and
other goods have more inelastic demands, so their taxes should be
lowered and taxes on others should be raised. In a static model, the
Ramsey rule implies a particular tax rate for each good, but in the dynamic real world, the Ramsey rule implies a continual readjustment of
tax rates to reflect continual changes in demand elasticities.
Implementation of the Ramsey rule implies a flexible structure of
excise tax rates to reflect changes in demand elasticities, and a flexible
tax structure gives interest groups the incentive for continual rent
seeking. Thus, following McChesney (1987, 1997), taxpayers and potential taxpayers must continually engage in lobbying activities, with
all the associated rent-seeking losses, to prevent themselves from being taxed more heavily in the future. Potential taxpayers who drop out
of the political process will find themselves easy targets when excise
tax rates are readjusted to reflect any changes in the governments esti-
565
mated elasticities of demands. Because the tax system must be flexible to adapt to changes in the underlying demand elasticities, attempting to keep tax rates in conformity with the Ramsey rule will produce
continual rent-seeking losses.
When one considers the political environment within which excise
taxes are determined, if the legislature has as its goal designing a set of
excise taxes to conform with the Ramsey rule, it will not be able to
achieve that goal because the information to do so will be unavailable
to it. In the process of trying, it will encourage constant rent seeking
along with its associated costs. Because the tax structure must always
be subject to change to maintain tax rates implied by the Ramsey rule,
this encourages substantially more rent seeking than if tax rates were
set within a relatively inflexible fiscal constitution. If one includes all
costs associated with the tax system, including the excess burden and
political and rent-seeking costs, then when the political environment
within which taxes are created is taken into account, the welfare cost
of commodity taxation is likely to be lower, with fixed and uniform
rates set in a fiscal constitution instead of trying to satisfy the Ramsey
rule. The model developed below illustrates why this is the case.
POLITICAL COSTS AND

THE RAMSEY RULE
The concept of rent seeking, following Tullock (1967) and Krueger

(1974), is well established in the public choice literature, but as
Holcombe (1998) noted, it is rarely applied to issues of taxation. Taxes
impose a welfare cost in many ways, and the Ramsey rule was designed to minimize one component of the welfare cost of taxation: the
excess burden. Taxes also impose compliance costs on taxpayers, as
Slemrod and Sorum (1984) noted, and impose administrative costs on
government. But although public finance has traditionally recognized
the excess burden, compliance, and administrative costs of taxation, it
has almost completely ignored the political costs of the tax system.
The political costs of taxation are those costs incurred by taxpayers
who engage in rent seeking to try to have the tax code altered to benefit
566
them or to protect themselves from having the tax code changed in a

manner that might hurt them. Political costs also include those costs
incurred by government to interact with citizens and interest groups
who lobby for and against changes in the tax code, as well as the governments cost in making the political decisions that determine the tax
code. These political costs have barely been noted in the taxation literature, but on the basis of limited data, Holcombe (1997) estimated that
they could be in the neighborhood of 10% of total tax revenues collected. If this figure is close, political costs are a substantial portion of
the total welfare cost of taxation.
Consider two alternative tax structures: one that imposes a sales tax
with a uniform rate on all retail purchases and another that attempts to
impose excise taxes conforming to the Ramsey rule on all retail purchases. The standard public finance approach to taxation would argue
that the excise taxes would be more efficient because they would minimize the excess burden of taxation. The foregoing analysis points out
the flaws in the standard public finance approach. First, the legislature
would have insufficient information to actually implement the
Ramsey rule, so that goal could not be achieved in any event; second,
the political process that produces the tax structure would result in a
substantial political cost associated with trying to implement the
Ramsey rule as various interest groups tried to minimize the taxes they
had to pay. If the fiscal constitution required a uniform rate on all retail
sales, the incentive to lobby for a lower tax share would be removed,
lowering the political costs of the tax system.
For the reasons given above, it is unlikely that the political system
would be able to produce a set of excise taxes conforming to the
Ramsey rule. The model in the following section reinforces this conclusion. But even if it did, the welfare savings from the reduction in the
excess burden of taxation would have to be weighed against the political costs generated by rent-seeking behavior, and those rent-seeking
losses may outweigh any reduction in the excess burden of taxation.
When the political system that determines the tax structure is taken
into account, the Ramsey rule has substantial flaws as a guide to tax
policy.
567
POLITICAL INCENTIVES
There is a line of reasoningfollowing Becker (1983), Wittman

(1989), and, with regard to tax policy specifically, Hettich and Winer
(1988)arguing that the political marketplace has forces that make
political outcomes as efficient as market outcomes and that pull the tax
structure toward efficiency. However, other lines of reasoning argue
that interest group politics results in policies that further special interests over the general public interest (Weingast, Shepsle, and Johnsen
1981; Holcombe 1985), that rent-seeking activity imposes substantial
political costs on the economy and leads to an inefficient use of resources (Tullock 1967; Krueger 1974), and that some interest groups
have organizational advantages over others, giving some groups advantages over others in interest group politics (Olson 1965). Because
excise taxes that follow the Ramsey rule exert greater costs on some
than others, attempts to implement the Ramsey rule create political incentives to move tax rates toward more uniformity and away from the
tax structure that would be consistent with the Ramsey rule.
As argued by Tullock (1967), interest groups have an incentive to
expend resources in rent seeking up to the expected value of the gain
from the rent-seeking activity. If the Ramsey rule were actually implemented for excise taxes, it would impose greater costs on those trading
in markets with more inelastic demands, giving them a greater incentive to incur political costs to lower their tax rate than those with lower
rates would have to fight against a tax increase. Those with relatively
inelastic demands would be willing to incur greater political costs to
lower their tax rates than those with relatively elastic demands would
be willing to incur to prevent theirs from being raised. The result will
be that tax rates will be pushed toward uniformity because of the political incentives, even if rates conforming to the Ramsey rule were
somehow implemented to begin with. The key component in this argument is that the goal of the Ramsey rule is to minimize the excess burden of taxation, whereas taxpayers will want to minimize the combination of the excess burden plus their tax payments, and the Ramsey
rule would place a much greater total tax burden on those trading in
markets with more inelastic demands.
Consider a simple example. Figure 1 represents the market for two
goods, one with relatively elastic demand DE and the other with rela-
568
tively inelastic demand DI, such that with no taxes, both goods have
perfectly elastic supply curve S and market equilibrium prices and
quantities P* and Q*. If all demand and supply curves are straight
lines and supply is perfectly elastic, the Ramsey rule is implemented
by levying tax (P1 P *) on the good with the more elastic demand
and (P2 P *) on the good with the more inelastic demand, so that after the tax, the good with DI sells for P2 and the good with DE sells for
P1 . Both goods see an identical percentage decline in their quantity exchanged, from Q* to Q. To see that this is so, note that representing
the total tax revenue from the excise tax as TR, the tax revenue for any
good, i, meeting the above conditions is
TR = ( Pi P*) Q,
(1)
and the excess burden, EB, is

EB = 1 2 ( Pi P*) (Q * Q ).
(2)
Dividing (2) by (1), simplifying gives the excess burden as a fraction of total tax revenues collected:
EB TR = (Q* Q)2Q.
(3)
Under the above assumptions, the ratio of the excess burden to total
tax revenues is a function of the reduction in the quantity exchanged
only and is not dependent on the tax rates or prices, which differ depending on the demand elasticities. Thus, for the assumptions above
(perfectly elastic supply curves; linear demand curves), the Ramsey
rule is satisfied when the excise taxes cause the same percentage decline in the quantity exchanged for all goods.
The application of the Ramsey rule imposes larger costs on markets
with more inelastic demands both because those markets have higher
tax burdens imposed and because the excess burdens, which are proportional to their taxes, are higher. If the Ramsey rule is imposed, this
gives groups with more inelastic demands a greater incentive to engage in rent-seeking costs to try to lower their taxes than groups with
elastic demands, which have to fight against higher taxes. In the twogood case represented in Figure 1, assume that with taxes conforming
to the Ramsey rule imposed, those trading in the market with DI go to
569
P2
P1
P*
DE
DI
Q1
Q Q2 Q*
Figure 1: Excise Taxes Placed on Two Goods
the legislature and argue that they really have the more elastic demand,
and rather than their paying tax P2 P * with tax P1 P * on the other
good, those taxes should really be reversed. If they could get their tax
lowered from P2 P * to P1 P *, their gain would be
GI = ( P2 P1 ) Q+ 1 2 ( P2 P1 ) (Q2 Q ),
(4)
where the term before the plus sign equals the gain from the lower
taxes imposed on the group, and the term after the plus sign represents
the gain from the lower excess burden. Equation (4) simplifies to
GI = 1 2 ( P2 P1 ) ( 3Q2 Q ).
(4)
Similarly, if the group trading in the more elastic good had its tax
raised to the level the Ramsey rule specifies for the less elastic good,
its loss would be
GE = ( P2 P1 ) Q1 + 1 2 ( P2 P ) (Q Q1 ),
(5)
where, as above, the term before the plus sign equals the increased
taxes it has to pay, and the term after the plus sign equals the increase
in that groups excess burden. Simplifying Equation (5) yields
570
GE = 1 2 ( P2 P1 ) (Q1 + Q ).
(5)
One can see that Equation (4) is larger than Equation (5) because
both share the common elements 1 2 (P2 P1 ), and dropping both from
each, one can see that
Q1 + Q < 2Q < 3Q2 Q.
(6)
Thus, the group with the inelastic demand and facing the higher taxes
under the Ramsey rule has a greater incentive to lobby for lower taxes
than the group with the elastic demand, which has to lobby against
higher taxes. This unequal political pressure pushes toward more uniformity in excise tax rates and away from the tax rates specified by the
Ramsey rule.
INTEREST GROUPS AND THE RAMSEY RULE
The simple model in the previous section shows that even if an excise tax structure begins in conformance with the Ramsey rule, political forces work to create an excise tax structure with more uniform excise tax rates than the Ramsey rule implies. Common sense accords
with this result. Groups that have higher costs imposed on them by the
tax system have a greater incentive to incur political costs to change
the system than groups that have lower costs imposed on them. The
Ramsey rule, by design, imposes higher costs on inelastically demanded goods than those with more elastic demands, giving those
who trade in the more inelastic markets a greater incentive to incur political costs to get their taxes lowered. Because those in markets with
more inelastically demanded goods have a greater incentive to incur
political costs to lower their taxes, political pressures will tend to reduce their taxes relative to those in markets with more elastic demand,
pushing the excise tax system away from conformation with the
Ramsey rule.
Even a general sales tax that taxes all goods at the same rate places a
higher tax burden on markets with more inelastic demands. Referring
again to the above example, if all goods are taxed at P1 P * , inelastic
goods pay (P1 P *) Q2 in taxes and suffer an excess burden of
571
(P1 P *) (Q * Q2 ), whereas the burden on elastically demanded goods is (P1 P *) Q in taxes plus an excess burden of
1
2 ( P1 P *) ( Q * Q ). Comparing the two in an inequality, after dividing through by the common term (P1 P *), yields
1
Q2 + 1 2 (Q * Q2 ) > Q + 1 2 (Q * Q ).
(7)
The inequality in Equation (7) simplifies to Q2 > Q , which, by reference to Figure 1, is clearly true. All this says is that the tax paid plus the
excess burden is higher as a percentage of the total cost of the goods
for more inelastically demanded goods than for those with more elastic demands, giving inelastic demanders a bigger incentive to lobby
for tax rate reductions even when the tax rates are the same for all
goods. Intuition supports this because inelastic demanders pay more
of the tax, whereas elastic demanders avoid more of it by substituting
out of the taxed good.
Assume that excise tax rates are flexible to accommodate the
changes that would be necessary to maintain conformance with the
Ramsey rule. Next, assume that because of the informational problems discussed above, actual excise tax rates will be determined by the
strength of lobbying efforts of potential taxpayers rather than by actual demand elasticities. Then, assume that lobbying efforts are proportional to the potential cost that taxes will place on that group. It follows from Equation (7) that inelastically demanded goods will have a
lower tax rate than elastically demanded goods, rather than a higher
rate as the Ramsey rule would dictate. Following this logic, the creation of political institutions that would allow an omniscient and benevolent government to set taxes to conform to the Ramsey rule would
result in a tax structure with a greater excess burden than completely
uniform tax rates, once the assumption of omniscience is dropped and
interest group politics is incorporated into the political environment.
This conclusion is at odds with that of Becker (1983), Wittman
(1989), and Hettich and Winer (1988), who argue that interest group
politics in the political marketplace should result in an efficient allocation of resources. The conclusion is different because the assumptions
of the models are different. Both rely on the relative strength of opposing interest groups, but the biggest omission in this model compared
with the above-cited authors is that the expenditure side of the budget
572
is left out. Interests lobby for lower taxes on themselves, but nobody in
this model is lobbying for more revenue. But real-world debates about
tax policy are this way too. Revenues are collected by the treasury, and
there is at best minimal connection between the revenues collected
and the expenditures they finance. Especially with smaller revenue
sources such as excise taxes, taxpayers view the taxes as a cost, but no
opposing interests in the political process view that revenue as their
gain.2 At the federal level, for example, total excise tax collections
comprise only 3.5% of total federal tax receipts, so interest groups that
desire higher expenditures are unlikely to lobby for increases in excise
taxes.
If the assumption that excise tax rates are designed by an omniscient and benevolent government is replaced by the assumption that
excise tax rates are a product of the political process, the flexible tax
structure that would be necessary to maintain a system of excise taxes
conforming to the Ramsey rule would result in a tax structure with a
greater excess burden than a sales tax with a uniform rate that raised
the same amount of revenue.3
IS THE RAMSEY RULE WRONG?
The Ramsey rule says that under certain assumptions, the burden of
excise taxes is minimized when all goods are taxed in inverse proportion to their elasticities of demand. As with any deductive conclusion,
the Ramsey rule follows from certain assumptions. Setting excise
taxes according to the Ramsey rule will minimize the excess burden of
excise taxation if all goods are assumed to have perfectly elastic supply curves and if purchasers have separable preferences for all goods,
among other assumptions. There is no flaw in the logic of Ramseys
(1927) argument: Ramseys conclusions follow from his assumptions.
However, if the Ramsey rule is taken as a guide to public policy toward
excise taxes, then the preceding analysis claims that the models assumptions lead to a conclusion that is inappropriate as a guide to public policy.
All economic models, including the model that demonstrates the
Ramsey rule, make simplifying assumptionsand frequently, unreal-
573
istic assumptionsto better understand phenomena that occur in the

real world. This is the whole purpose of modeling exercises. If one
could understand the real world without reference to the model, then
there would be no reason to develop the model.4 Any model assumes
away those features of the real world that are unnecessary to understand the phenomenon being modeled and sometimes makes unrealistic assumptions to deliberately highlight the phenomenon under question. As Holcombe (1989) argued, the simplifying and unrealistic
assumptions of the model are not faults of the model but virtues because they highlight the particular phenomenon in question and make
it as easy as possible to understand.
Because every economic model makes simplifying assumptions,
no model can be ideal for analyzing all phenomena. No model can be
expected to offer any insight on those things the model has assumed
away, and it is here that the Ramsey rule comes up short as an instrument of public policy. The model behind the Ramsey rule does not
take into account the political environment within which tax policy is
created, so it cannot be expected to offer insight on the creation of optimal tax policy in the real world where tax policy is a creation of politics. The Ramsey rule correctly shows that under certain conditions,
the excess burden of excise taxes is minimized when excise tax rates
are set in inverse proportion to the taxed goodselasticities of demand,
but it does not demonstrate that rates could ever be set that way or that
there is any political decision-making process that would lead to excise taxes that conformed to the Ramsey rule.
Buchanan (1975) noted that standard public finance tends to analyze policy as if the economist were offering advice to a benevolent
dictator and that the standard analysis prior to public choice assumed
different motivations for those in the public sector from those in the
private sector. The innovation that public choice offers economics,
Buchanan argued, is that it analyzes the public sector using the same
behavioral assumptions that economists use to analyze the private sector. Individuals, whether in the public or private sectors, are assumed
to be utility maximizers who respond to the incentives they face and
make use of the information available to them. Methodologically, this
article takes Buchanans vision of public choice and applies it to the
Ramsey rule. Rather than assuming that once the government knows it
574
can minimize the excess burden of excise taxes by applying the

Ramsey rule, it will design excise taxes that way, this article analyzes
the political environment within which excise taxes are created to see
if it would be good public policy to argue that government should try
to implement the Ramsey rule. Once the political environment is taken
into account, it becomes apparent that the Ramsey rule does not describe an achievable policy goal, and so it should not be promoted as a
component of an optimal tax policy.
The Ramsey rule is not wrong in the sense that it contains a logical
flaw, but if it is taken to be a rule that describes an optimal tax policy
that a legislature should try to implement, it is flawed because it leaves
out a crucial element in the process of determining tax policy.
THE RAMSEY RULE AS A CRITERION

FOR OPTIMAL TAXATION
Ramseys (1927) intention was to define the conditions under

which a structure of excise taxes would impose the minimum excess
burden for the amount of revenue collected. In this sense, the Ramsey
rule could be said to identify the optimal structure of excise taxes.
However, optimal taxation has taken on a broader meaning following
the work of Mirrlees (1971, 1976) and Diamond and Mirrlees (1971a,
1971b). According to this literature, optimal tax structures maximize
a social welfare function that is a function of the welfare of all individuals and have a substantial redisributive component. Following the
methodological discussion above, Diamond and Mirrlees might find
fault with a narrow application of the Ramsey rule because it neglects
to consider the redistributive nature of the tax system. Thus, optimal
taxation, according to Diamond and Mirrlees, is potentially inconsistent with a policy of trying to implement the Ramsey rule. Optimal
taxation may mean more than simply minimizing the excess burden of
taxation or even minimizing the sum of excess burden, compliance,
administrative, and political costs.
Buchanan (1976) criticized the optimal tax literature described by
Mirrlees (1976) because it fails to take account of the way in which tax
revenues are spent. Buchanans criticism extends beyond that litera-
575
ture and applies to the Ramsey rule as well. The standard public finance literature treats taxes as a cost that government imposes on its
citizens. Buchanan advocated a fiscal exchange model of taxation, in
which taxes are viewed as the price paid for government goods and
services. Applying the fiscal exchange model to excise taxes, optimal
excise taxes would be designed to conform to the benefit principle of
taxation rather than the Ramsey rule. The benefit principle is applied
most straightforwardly with user charges, such as tolls for financing
roads. In this case, the toll acts just like a price, and there is no excess
burden because the price efficiently rations the use of the good.5 In deriving his rule to minimize the excess burden of excise taxes, Ramsey
(1927) assumed away this possibility of completely eliminating the
excess burden by analyzing the tax structure independently of expenditures. If user charges are not feasible, users could be taxed on their
use of a complementary good, such as applying an excise tax to motor
fuels to finance roads. Although not as directly as a price on road use,
the higher price of gasoline because of the tax would ration road use
someso in a manner similar to road pricing, it would lower the excess burden of taxation, again when taxes and expenditures are considered together.
Following this line of reasoning, excise taxes may be justified to
implement the benefit principle, and to the degree that they act like
prices on the goods they finance, they can reduce the excess burden of
taxes. The larger point, though, is that building on Buchanan (1976),
when both the revenue and expenditure sides of the budget are considered, the Ramsey rule is unlikely to minimize the excess burden of excise taxation, even when assuming an omniscient and benevolent government. Taxes designed to conform to the benefit principlerather
than the Ramsey rulecan completely eliminate the excess burden if
they can be designed to mimic market prices.
Even this conclusion needs to be tempered when the political environment is incorporated into the analysis. It is not always obvious who
benefits from particular expenditures, so even revenues from earmarked excise taxes are subject to appropriation through the political
process. For example, gasoline taxes, which largely are earmarked for
roads, have sometimes been diverted to finance mass transit expenditures or even bike paths under the justification that roadway users ben-
576
efit because these alternative modes of transportation reduce highway

traffic. Once the tax is established, there is nothing to prevent
rent-seeking behavior from interest groups that want a share of the
revenues.
THE RAMSEY RULE AND

THE FISCAL CONSTITUTION
Buchanan (1967, 300) argued the merits of a fiscal constitution that

is quasi-permanent and long-lasting rather than allowing fiscal flexibility that makes governmental processes nothing more than available means through which separate coalitions can exploit each other.
Despite the Ramsey rules longstanding position in the theory of optimal taxation, this analysis suggests that the Ramsey rule should not be
incorporated as a part of the fiscal constitution for three main reasons.
First, the information needed to implement the Ramsey rule is not
readily available to those who design the tax structure. If government
is not omniscient, estimates of demand elasticities necessary to implement the Ramsey rule will have to be determined politically, and it is
unlikely that the political process will be a good source of economic
data that are not readily observable. Second, an analysis of the political process underlying the determination of excise tax rates shows that
political pressures will push for lower excise taxes on inelastically demanded goods relative to elastically demanded goods, which is exactly the opposite of the tax structure that would satisfy the Ramsey
rule. Forces in the political marketplace work against the ability of a
democratic government to implement the Ramsey rule. Third, because the underlying economic data are continually changing, a tax
structure that implements the Ramsey rule will have to be flexible to
allow for tax changes in response to changes in demand elasticities.
There are strong arguments in favor of a relatively inflexible fiscal
constitution, however, to prevent interest groups from engaging in
rent-seeking activities to alter the fiscal constitution in their favor. Arguments for an inflexible fiscal constitution argue against the flexibility that would be needed to incorporate the Ramsey rule as a part of the
fiscal constitution.
577
To the degree that excise taxes are used as a tool of public finance,
they should be designed to conform with the benefit principle of taxation rather than the Ramsey rule, and they should be designed as a relatively permanent feature of a relatively inflexible fiscal constitution.
The Ramsey rule has been an unquestioned component of optimal tax
theory for three quarters of a century, but when it is analyzed within
the context of the actual political process within which taxes are designed rather than under the assumption that the tax structure is created by an omniscient and benevolent government, there is good reason to reconsider the Ramsey rule as a guide to optimal tax policy.
NOTES
1. Holcombe (1996) described the Ramsey rule in more detail. The rule can be modified to
take into account complications such as differences in supply elasticities and other factors, but
such complications are irrelevant to the points made in this article.
2. This would not be the case if the revenues were earmarked, but earmarking moves beyond
the bounds of the Ramsey rule, which simply looks at the collection of taxes independently of
where the revenue is spent.
3. The model presented here looks at the relative excise tax rates on two goods, but because
it does not incorporate the expenditure side, it does not determine an absolute level of taxes and
so does not determine an absolute level of excess burden.
4. This is not strictly true. McCloskey (1983) argued that models are employed as persuasive devices, and sometimes models are developed for purely aesthetic reasons. As Holcombe
(1989, 9) noted, quoting from an unknown source, Economists, like artists, are often in love
with their models.
5. This assumes that the road would be congested without the toll and that the toll rations the
use of the road. Without tolls, lack of congestion may signal excess capacity (the case is clearest
for roads with multiple lanes in each direction), in the sense that there is a marginal cost associated with building capacity, but the marginal user of the road places almost no value on its use.
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Buchanan, James M. 1967. Public finance in democratic process. Chapel Hill: University of
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Holcombe, Randall G. 1985. Public finance and the political process. Carbondale: Southern Illinois University Press.
. 1989. Economic models and methodology. New York: Greenwood.
. 1996. Public finance: Government revenues and expenditures in the United States economy. St. Paul, MN: West.
. 1997. Selective excise taxes from an interest-group perspective. In Taxing choice: The
predatory politics of fiscal discrimination, edited by William F. Shughart II, 81-103. New
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. 1998. Tax policy from a public choice perspective. National Tax Journal 51 (2): 359-71.
Krueger, Anne O. 1974. The political economy of the rent-seeking society. American Economic
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McChesney, Fred S. 1987. Rent extraction and rent creation in the economic theory of regulation. Journal of Legal Studies 16 (1): 101-18.
. 1997. Money for nothing: Politicians, rent extraction, and political extortion. Cambridge, MA: Harvard University Press.
McCloskey, Donald M. 1983. The rhetoric of economics. Journal of Economic Literature 21 (7):
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Mirrlees, James A. 1971. An exploration in the theory of optimum income taxation. Review of
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. 1976. Optimal tax theory: A synthesis. Journal of Public Economics 6 (4): 327-58.
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Randall G. Holcombe is the DeVoe Moore Professor of Economics at Florida State University, where he has taught since 1988. Prior to coming to Florida State, he was on the
faculty at Auburn University and Texas A&M University. His primary research interests
are in the areas of public finance and public choice. He is author of 10 books and more
than 100 articles. His most recent book is From Liberty to Democracy: The Transformation of American Government (2002).

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The Ramsey Rule Reconsidered

>> Version of Record - Nov 1, 2002

THE RAMSEY RULE RECONSIDERED

One of the most enduring and least questioned concepts of optimal

Holcombe / THE RAMSEY RULE RECONSIDERED

THE INFORMATIONAL REQUIREMENTS

PUBLIC FINANCE REVIEW

nevolence is retained, but the assumption of omniscience is dropped,

FLEXIBLE TAX RATES AND

Holcombe / THE RAMSEY RULE RECONSIDERED

POLITICAL COSTS AND

The concept of rent seeking, following Tullock (1967) and Krueger

PUBLIC FINANCE REVIEW

them or to protect themselves from having the tax code changed in a

Holcombe / THE RAMSEY RULE RECONSIDERED

There is a line of reasoningfollowing Becker (1983), Wittman

PUBLIC FINANCE REVIEW

and the excess burden, EB, is

Holcombe / THE RAMSEY RULE RECONSIDERED

Figure 1: Excise Taxes Placed on Two Goods

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INTEREST GROUPS AND THE RAMSEY RULE

Holcombe / THE RAMSEY RULE RECONSIDERED

PUBLIC FINANCE REVIEW

IS THE RAMSEY RULE WRONG?

Holcombe / THE RAMSEY RULE RECONSIDERED

istic assumptionsto better understand phenomena that occur in the

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can minimize the excess burden of excise taxes by applying the

THE RAMSEY RULE AS A CRITERION

Ramseys (1927) intention was to define the conditions under

Holcombe / THE RAMSEY RULE RECONSIDERED

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efit because these alternative modes of transportation reduce highway

THE RAMSEY RULE AND

Buchanan (1967, 300) argued the merits of a fiscal constitution that

Holcombe / THE RAMSEY RULE RECONSIDERED

PUBLIC FINANCE REVIEW

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