Direct versus Indirect Taxation The Design of the Tax….pdf

Direct versus Indirect Taxation: The Design of the Tax Structure Revisited∗ Helmuth Cremer IDEI and GREMAQ, University of Toulouse and Institut Universitaire de France Pierre Pestieau CREPP, University of Li`ege, CORE and DELTA Jean-Charles Rochet IDEI and GREMAQ, University of Toulouse and Institut Universitaire de France April 1997, revised October 1999 ∗We would like to thank Dieter B¨os, Christophe Chamley, Jacques Cr´emer, Jonathan Hamil- ton and, particularly, Alain Jousten and the two referees for their comments. Abstract This paper studies the optimal direct/indirect tax mix problem when individuals dif- fer in several unobservable characteristics (productivity and endowments). It presents general expressions for the optimal commodity tax rates and proves that contrary to Atkinson and Stiglitz’s (1976) result, differential commodity taxation remains a useful instrument of tax policy even if preferences are separable between labor and produced goods. When cross substitution effects are zero, the expressions resemble traditional many households Ramsey rules. In a Cobb-Douglas illustration, where endowments differ only in good 1 (interpreted as “wealth”), the tax on good 2 provides an indirect way to tax the unobservable wealth. JEL classifi cations: H21; H23 Keywords: optimal taxation; direct/indirect tax mix; multidimensional screening 1 Introduction The choice between direct and indirect taxation is one of the “oldest issues of taxation policy” (Atkinson (1977)). It raises challenging theoretical questions and is of significant policy relevance. The theo