Prices, Non-homotheticities, and Optimal Taxation

90 Pages Posted: 1 Jun 2019 Last revised: 13 Aug 2021

See all articles by Xavier Jaravel

Xavier Jaravel

London School of Economics & Political Science (LSE) - Department of Economics

Alan Olivi

Independent

Date Written: August 13, 2021

Abstract

We characterize theoretically and quantitatively the effects of price changes on optimal tax design in the presence of non-homothetic preferences. We provide decompositions showing how price changes transform the cost-benefit analysis of tax policy, as they affect both the marginal social value of redistribution and the efficiency cost of taxation. We find that, rather than offsetting price changes, the optimal tax system amplifies their redistributive effects. Price changes affect the marginal utility of disposable income and generate income effects such that it is optimal to increase redistribution toward households with a higher marginal propensity to spend on goods with falling relative prices. Optimal tax design creates a feedback loop whereby taxes shift demands for products, inducing a further change in prices in general equilibrium, and a new response of the tax schedule. With a quantitative model matching observed non-homotheticities and the empirical elasticity of prices to market size in the United States, we find large impacts on optimal marginal tax rates and welfare across the skill distribution. Due to the amplification channel, (i) the optimal tax schedule is more redistributive when accounting for non-homothetic spending patterns, (ii) observed heterogeneous inflation rates, which are lower for luxuries relative to necessities in the United States, generate a regressive tax response.

Keywords: Optimal Taxation; Innovation; IRS

JEL Classification: H21; 030

Suggested Citation

Jaravel, Xavier and Olivi, Alan, Prices, Non-homotheticities, and Optimal Taxation (August 13, 2021). Available at SSRN: https://ssrn.com/abstract=3383693 or http://dx.doi.org/10.2139/ssrn.3383693

Xavier Jaravel (Contact Author)

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom
7456842728 (Phone)
NW12AR (Fax)

Alan Olivi

Independent ( email )

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
265
Abstract Views
1,145
Rank
240,617
PlumX Metrics