Reforming the Direct-Indirect Tax Mix
Posted: 30 May 2002
This paper provides a new framework for evaluating the welfare effects of commodity tax reforms. It is shown that tax reforms are welfare improving if and only if they satisfy the following intuitive property: on average, consumer prices fall for commodities with high marginal excess burdens. The rule is then applied to analyze a shift from differentiated commodity taxation to direct flat-rate taxation of labour income. The welfare impact of such reforms can be decomposed into two effects: (i) the increase in welfare associated with substitution among taxed commodities, and (ii) the loss in welfare associated with substitution between commodities and leisure. On balance, a shift towards direct taxation is desirable when inter-commodity substitution effects are large relative to commodity-leisure substitution effects. The analysis allows us to reconcile the apparently conflicting results of the tax reform and optimal taxation literatures.
Keywords: Uniform commodity taxation, tax reform, excess burden
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