Optimal Commodity Taxation in the Presence of Involuntary Unemployment

This paper addresses the optimal commodity taxation when involuntary unemployment arises from redistributive fiscal policies, e.g., a progressive income tax system and social insurance/welfare programs. This setting deals with a new dimension of distortions: the “between-states” (employment state vs. unemployment state) consumption choice distortion along with the usual “within-state” distortion conditional on a given state. We derive the optimal commodity taxation rule in the presence of the redistributive fiscal policies in a simplified ‘general-equilibrium’ efficiency wage model with effort and commodity choices. In contrast to the conventional results by Ramsey (1927) and Atkinson and Stiglitz (1976) that consider the within-state distortion only, we show that under the weakly separable utility and the constant marginal cost technology, uniform commodity taxation is optimal only when the government can choose all commodities’ tax rates. If at least one good’s tax rate is fixed at a certain level (e.g., due to redistributive purpose or to foreign competition), non-uniform commodity taxation is generally optimal. The intuition is that a deviation from uniform commodity taxation can alleviate the betweenstates distortion, moral hazard arising from a progressive income tax system and social insurance/welfare programs. This gain, combined with resulting greater effort and higher utilization of labor (i.e., lower unemployment), can outweigh the within-state consumption choice distortions from non-uniform taxation. Useful policy implications are also discussed.