Informality, Consumption Taxes, and Redistribution

91 Pages Posted: 29 Jun 2020

See all articles by Pierre Bachas

Pierre Bachas

Princeton University

Lucie Gadenne

University of Warwick

Anders Jensen

Harvard University - Harvard Kennedy School (HKS)

Date Written: June 2020

Abstract

Can consumption taxes reduce inequality in developing countries? We combine household expenditure data from 31 countries with theory to shed new light on the redistributive potential and optimal design of consumption taxes. We use the type of store in which purchases occur to proxy for informal (untaxed) consumption. This enables us to characterize the informality Engel curve: we find 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. We extend the standard optimal commodity tax model to allow for informal consumption and calibrate it to the data to study the effects of different tax policies on inequality. Contrary to consensus, we show that consumption taxes are redistributive, lowering inequality by as much as personal income taxes. Once informality is taken 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.

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Suggested Citation

Bachas, Pierre and Gadenne, Lucie and Jensen, Anders, Informality, Consumption Taxes, and Redistribution (June 2020). NBER Working Paper No. w27429, Available at SSRN: https://ssrn.com/abstract=3637730

Pierre Bachas (Contact Author)

Princeton University

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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