Taxing Consumption in Unequal Economies

This paper shows that linear consumption taxes are a powerful tool to implement efficient redistribution. We derive this result in an estimated life-cycle economy with labor and capital income risk that reproduces the distribution of income and wealth in the United States. Optimal policy calls for raising all fiscal revenues from consumption, and providing social insurance via a highly progressive wage tax schedule. Capital income and wealth should not be taxed. This policy reduces inequality and increases productivity, and brings large welfare gains both relative to the status-quo and to the case where consumption is not taxed. More than two-thirds of these gains are due to redistribution. Considering transitional dynamics, we show that our reform also generates large welfare gains in the short run.