A PARETO-IMPROVING COMMODITY TAX-REFORM UNDER A SMOOTH NONLINEAR INCOME-TAX

This paper analyzes the welfare effects of commodity tax reform in an economy with a nonlinear income tax and linear commodity taxes. The main result is that we can find a tax reform program that improves every consumer's utility in the Pareto sense unless efficiency loss in the economy is minimized under incentive compatibility. The tax reform rule proposed here applies to a broad class of economies with arbitrary smooth income taxes. The expenditure function approach makes our analyses clear and simple. Some intuition is presented on the role of commodity taxation in a mixed tax economy. The relationship with previous work in optimal tax and tax reform theory is also discussed. We extend our result to the case where the government spends tax revenue to provide a public good.