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On the Optimal Design of Consumption Taxes

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  • Michael Barczay

    (European University Institute and Study Center Gerzensee)

Abstract

This paper studies the optimal design of differentiated consumption taxes in the presence of progressive labor income taxes and capital income taxation. A quantitative heterogeneousagent model with non-homothetic preferences and uninsurable idiosyncratic risk is estimated using US consumption and price data to match expenditure patterns across the income distribution. Solving the Ramsey problem in which the government jointly chooses labor income and commodity taxes, the optimal policy prescribes a subsidy on necessities of -52% and a positive tax of 7% on luxuries, accompanied by a reduction in labor tax progressivity. Three mechanisms account for these results: subsidized necessities provide consumption insurance, taxation of luxuries acts as an implicit tax on existing wealth, and differentiated rates strengthen labor supply incentives among highly productive households.

Suggested Citation

  • Michael Barczay, 2025. "On the Optimal Design of Consumption Taxes," Working Papers 25.03, Swiss National Bank, Study Center Gerzensee.
    • Handle: RePEc:szg:worpap:2503
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    References listed on IDEAS

    as
    1. Carroll, Christopher D., 2006. "The method of endogenous gridpoints for solving dynamic stochastic optimization problems," Economics Letters, Elsevier, vol. 91(3), pages 312-320, June.
    2. Auerbach, Alan J & Kotlikoff, Laurence J, 1987. "Evaluating Fiscal Policy with a Dynamic Simulation Model," American Economic Review, American Economic Association, vol. 77(2), pages 49-55, May.
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