Follow us
Publications Commentary Research People Events News Resources and Videos About IFS
Home Publications Informality, Consumption Taxes and Redistribution

Informality, Consumption Taxes and Redistribution

IFS Working Paper W20/14

Can consumption taxes reduce inequality in developing countries? We combine household expenditure data from 31 countries with theory to shed new light on the redistributive potential and optimal design of consumption taxes. We use the place of purchase of each expenditure to proxy for informal (untaxed) consumption. This enables us to characterize the informality Engel curve: we find that the budget share spent in the informal sector steeply declines with income, in all countries. The informal sector thus makes consumption taxes progressive: households in the richest quintile face an effective tax rate that is twice that of the poorest quintile. We extend the standard optimal commodity tax model to allow for informal consumption and calibrate it to our data to study the effect of different tax policies on inequality. Contrary to consensus, we show that consumption taxes are redistributive, lowering inequality by as much as personal income taxes. These effects are primarily driven by the shape of the informality Engel curve. Once informality is taken into account, commonly used redistributive policies, such as reduced rates on necessities, have a limited impact on inequality. In particular, subsidizing food cannot be justified on equity or efficiency grounds in several poor countries.

More on this topic

IFS Working Paper W22/16
This paper provides novel evidence on the trade-off between public service delivery and free riding in low- and middle-income countries.
IFS Working Paper W22/09
We draw on a cluster RCT in rural India of a sanitation labelled microcredit program, implemented by chance around the onset of a large sanitation policy comprising partial subsidies – Swacch Bharat or ‘Clean India’ Mission.
External publication
This note shows the results on firm size and effective tax rates for Ethiopia, where the corporate statutory tax rate is 30%.