London School of Economics EOPP: Economic Organisation and Public Policy Programme LSE
EOPP: Economic Organisation and Public Policy Programme

Current EOPP Research:
A Characteristics Approach to Optimal Taxation and Tax-Driven Product Innovation

Henrik Kleven (with Joel Slemrod, University of Michigan)

Abstract:

Any tax system imposing selective commodity taxation must have procedures for assigning different goods to tax-rate categories. Real-world tax legislation does this on the basis of observable characteristics, allowing the tax system to handle a constantly evolving set of available goods. We recast the theory of optimal tax taxation in the language of characteristics using Lancaster’s theory of consumer behavior, and present a model of tax-driven product innovation and optimal line drawing. Whenever the number of tax instruments is finite, tax systems have to draw lines that define tax-rate regions in characteristics space. Such lines are associated with notches in tax liability as a function of characteristics, creating incentives to produce socially inferior goods that are just on the low-tax side of the line. We show that a tax system that allows for tax-driven product innovation completely eliminates other technologically superior goods from the market. Second-best optimal tax systems draw lines so as to ensure that no new goods are being created for tax avoidance purposes, implying that the set of available goods (but not the demand for each available good) is first-best.

Related Paper

A Characteristics Approach to Optimal Taxation and Tax-Driven Product Innovation