Prices, Non-homotheticities, and Optimal Taxation
90 Pages Posted: 1 Jun 2019 Last revised: 13 Aug 2021
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: Suggested Citation