The Optimal Commodity Tax System as a Compromise between Two Objectives

Abstract

Policy analysis in applied fields such as agricultural, trade, environmental and development policy is still often undertaken within a first-best, rather than a more realistic second-best framework. The present paper seeks to contribute to changing this state of affairs by providing an intuitive explanation of what determines the optimal tax system. It derives and interprets an optimal tax formula for an economy with many goods to explain the optimal tax system as reflecting a trade-off between, on the one hand, the objective of encouraging the supply of labour to the market and, on the other hand, the objective of limiting the distortion of the marginal rate of substitution between produced goods. It illustrates this insight by a quantitative general equilibrium model which does not impose separability between consumption and leisure. The analysis clarifies issues of normalisation and deepens the insight due to Corlett and Hague (1953) that goods should be taxed according to their complementarity with leisure.