Informality, Consumption Taxes and Redistribution

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What is the redistributive capacity of taxes on consumption in developing countries? We combine household expenditure data from 32 countries with theory to establish the optimal design of consumption taxes and their impact on income inequality. We use the type of store in which purchases occur to proxy for informal (untaxed) consumption. In all countries, the budget share spent in informal stores steeply declines with income. This makes consumption taxes strongly progressive as the effective tax rate rises with income. We derive optimal tax policies by extending the canonical commodity tax model to allow for informal consumption and calibrate it to our data. Contrary to consensus, our results show that consumption taxes are redistributive and reduce inequality. Moreover, once informality is considered, the widespread policy of rate differentiation across goods has limited redistributive impact. In particular, reduced rates on necessities cannot be justified on equity grounds in the poorest countries.

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