A New Approach to Optimal Commodity Taxation

Abstract

This paper makes a fresh attempt at characterizing optimal commodity taxes. Under the usual assumptions, an extremely simple expression of second-best commodity taxes is derived, showing tax rates as functions of observable variables only, rather than as functions of unobservable variables such as compensated cross elasticities. The main formula is independent of special preferences, and independent of the number of commodities. It has a simple economic meaning and could be particularly useful for empirical research. Examples and remarks on the normalization problem are provided

The optimal commodity tax structure in a four-good model

“…conditions are expressed in terms of the demand response of the compensated inverse demand function, 6 and Homburg's (2006) condition in terms of the response of earnings to change in the respective consumption. 7 The optimal tax rules obtained in this paper are all expressed in terms of the compensated demand elasticities, which are evaluated by ordinary substitution terms, as are the IE and C-H rules.…”

“…7 "The response of earnings to a change in the respective consumption" is evaluated by the demand response of the inverse demand function. Homburg's (2006) condition that ranks optimal tax rates is not evaluated by the ordinary substitutability, i.e., the price response of the compensated demand function. 8 As with other studies on the commodity tax reform with revenue constraint, Konishi (1989) and Smart (2002) examined the welfare effect of changing the wage tax that accompanies the proportional reduction of the commodity taxes so as to maintain the tax revenue.…”