Informality, Consumption Taxes and Redistribution

93 Pages Posted: 3 Jun 2020

See all articles by Pierre Jean Bachas

Pierre Jean Bachas

World Bank

Lucie Gadenne

University of Warwick

Anders Jensen

Harvard University - Harvard Kennedy School (HKS)

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Date Written: June 1, 2020

Abstract

Can consumption taxes reduce inequality in developing countries? This paper combines household expenditure data from 31 countries with theory to shed new light on the redistributive potential and optimal design of consumption taxes. It uses the place of purchase of each expenditure to proxy for informal (untaxed) consumption which enables characterizing the informality Engel curve. The analysis finds that the budget share spent in the informal sector steeply declines with income, in all countries. The informal sector thus makes consumption taxes progressive: households in the richest quintile face an effective tax rate that is twice that of the poorest quintile. The paper extends the standard optimal commodity tax model to allow for informal consumption and calibrates it to the data to study the effects of different tax policies on inequality. Contrary to consensus, the findings show that consumption taxes are redistributive, lowering inequality by as much as personal income taxes. These effects are primarily driven by the shape of the informality Engel curve. Taking informality into account, commonly used redistributive policies, such as reduced tax rates on necessities, have a limited impact on inequality. In particular, subsidizing food cannot be justified on equity or efficiency grounds in several poor countries.

Keywords: Labor Markets, Tax Administration, Tax Law, Economic Adjustment and Lending, Macro-Fiscal Policy, Taxation & Subsidies, Public Finance Decentralization and Poverty Reduction, Public Sector Economics, Tax Policy, Rural Labor Markets, Gender and Development

Suggested Citation

Bachas, Pierre Jean and Gadenne, Lucie and Jensen, Anders, Informality, Consumption Taxes and Redistribution (June 1, 2020). World Bank Policy Research Working Paper No. 9267, Available at SSRN: https://ssrn.com/abstract=3616476

Pierre Jean Bachas (Contact Author)

World Bank ( email )

1818 H Street, NW
Washington, DC 20433
United States

Lucie Gadenne

University of Warwick ( email )

Gibbet Hill Rd.
Coventry, West Midlands CV4 8UW
United Kingdom

Anders Jensen

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States

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