Working Paper: CEPR ID: DP14945
Authors: Lucie Gadenne; Anders Jensen; Pierre Bachas
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.
Keywords: household budget surveys; inequality; informality; redistribution; taxes
JEL Codes: E26; H21; H23; O23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Consumption taxes in developing countries (H29) | Reduce inequality (I14) |
| Budget share spent in the informal sector declines with income (E29) | Consumption taxes are progressive (H29) |
| Households in the richest quintile face higher effective tax rates than poorest quintile (H31) | Progressive nature of consumption taxes (H22) |
| Informal consumption patterns (D10) | Tax burdens (H22) |
| Tax policy (H29) | Income redistribution (H23) |
| Reduced tax rates on necessities (H29) | Limited impact on inequality (F61) |
| Informality Engel curve (D11) | Progressivity of consumption taxes (H22) |