Direct versus indirect taxation: the design of the tax structure revisited

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Abstract
This paper studies the optimal direct/indirect tax mix in a setting where individuals differ in several unobservable characteristics (productivity and endowments). Tax instruments (income and commodity taxes) are constrained solely by the information structure. It presents general expressions for the optimal commodity tax rates and proves that contrary to Atkinson and Stiglitz's (1976) result, differential commodity taxation remains a useful instrument of optimal tax policy even if preferences are separable between labor and produced goods. The following, more specific, results are also derived. First, when cross substitution effects are small the expressions resemble traditional (many households) Ramsey rules. Second, if differences in endowments are confined to some of the goods, the tax rate on goods in which endowments are zero is positively related to income elasticity. Finally, in a Cobb-Douglas illustration with two goods, where endowments differ only in good 1 (and are interpreted as "wealth"), the tax on good 2 provides an indirect way to tax the unobservable wealth. It is higher (i) the more significant are the wealth differentials, (ii) the stronger is the correlation between wealth and earning ability and (iii) the larger are the (political) weights attached to low wealth individuals.

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