Tuesday, January 21, 2014

Consumption taxation is not that regressive

It is a fact of life that governments need revenue. How to get this revenue without hurting the economy too much has been the topic of much research. Quite obviously, you first want to tax activities that are optimally discouraged, such as smoking and polluting. But that is not sufficient. You do not want to depress the labor supply and thus you want to avoid taking labor income. The alternative is taxing consumption, which you indeed want to discourage in favor of investment, but a consumption tax is deemed regressive and unfair: it hurts proportionally more the poor than the rich.

Nico Pestel and Eric Sommer claim that this perception may only hold in the short-term. Indeed, they find the standard result that a revenue-neutral switching from labor income tax to value-added tax is regressive in the short run. This seems to reverse itself in the longer run, though, thanks to a shift in the labor supply. Using a model estimated on German data, they highlight that the ones responding the most to the reduction in the wage taxation are indeed the poorest, and their response overcomes the progressivity of the income tax. The key here is also reducing payroll taxes which seem to be very discouraging for low income workers.

1 comment:

Anonymous said...

A related paper on the non-regressivity of consumption taxes, in a stylized quantitative model, is here:


It does some calculations motivated by earlier work of Gilbert Metcalf (cited therein).