In a world with perfect markets, the optimal fiscal policy would be to have zero taxes and subsidies, and let Adam Smith's invisible hand do its magic and bring us to a first best solution. However, in the presence of market imperfections, it becomes necessary to create a government that provides public goods such as security, justice, roads and other infrastructure necessary for the economic activity. In addition, the government also has redistributive concerns, and sectors such as health and education are crucial for the government to ensure universal access and equal opportunities. It is therefore necessary to have a fiscal policy that ensures the financing of all these activities.
The field of Optimal Taxation looks exactly at the most efficient way of collecting taxes. In the presence of externalities such as pollution or congestion, some taxes may actually make the economy more efficient. In this case, introducing a tax is improving economic efficiency because we are approaching the private cost of the social cost of a particular economic activity. However, generally these taxes are not sufficient to finance all the government’s activities, so it becomes necessary to use additional taxes that distort the economic activity, leading to a loss in efficiency.
This means that to fund any government activity it is necessary not only to withdraw the funds needed for this activity from the private economy but also to create distortions in the behavior of agents that increase the cost of taxation. When the tax is high this distortion can be so strong that sometimes, by increasing the tax rate, we end up collecting less revenue due to the contraction of economic activity.
Just like activities that cause negative externalities should be taxed, it is also true that activities with positive externalities should, in principle, be subsidized. However, we need to be very careful using subsidies. For example, when we think about pollution in cities arising from the use of cars, we can correct the overuse of cars by taxing gasoline and diesel, or we can have a similar effect by subsidizing public transportation. Although at first sight these policies seem identical, they are actually quite different. The first obvious difference is that the first increases the government’s fiscal revenue, while the second reduces it. Therefore, the first one is automatically disciplined by the pressure of tax-paying consumers, the latter one can grow without bounds, financing activities which in the end may no longer be welfare improving. For example, it may happen that people who would have walked now take the subway instead, because its price no longer reflects its cost. And at on the other side of every subsidy, there must also be a tax, distorting the economy to finance an activity which may in the end be distortionary itself.