Commodity Taxation in Welfare States

Unemployment is a central policy issue in countries with a “generous” welfare system that is hard to reform. This paper addresses why these countries tend to adopt high commodity tax rates in the optimal taxation context. We explore the role of commodity taxation in alleviating moral hazard and hence involuntary unemployment and then provide empirical evidence using data from OECD countries. At the heart of this paper is a new dimension of distortion, the “between-states” (employment state vs. unemployment state) consumption choice distortion, which contrasts with the usual “within-state” distortion conditional on the full employment state. Our results offer an explanation for the widely observed coexistence of direct and indirect taxation as well as non-uniform taxation.