<P> Optimal tax theory or the theory of optimal taxation is the study of designing and implementing a tax that reduces inefficiency and distortion in the market under given economic constraints . Generally , this criterion consists of individuals ' utility and the optimization problem involves minimizing the distortions caused by taxation . A neutral tax is a theoretical tax which avoids distortion and inefficiency completely . Other things being equal , if a tax - payer must choose between two mutually exclusive economic projects ( say investments ) that have the same pre-tax risk and returns , the one with the lower tax or with a tax exemption would be chosen by a rational actor . Thus economists argue that taxes generally distort behavior . </P>
an optimal tax is one that minimizes the
inefficiency and distortion in the market under given economic constraints