A Characteristics Approach to Optimal Taxation: Line Drawing and Tax‐Driven Product Innovation

• Published date: 01 April 2017
• DOI: http://doi.org/10.1111/sjoe.12174
• Date: 01 April 2017

Scand. J. of Economics 119(2), 240–267, 2017

DOI: 10.1111/sjoe.12174

A Characteristics Approach to Optimal

Taxation: Line Drawing and Tax-Driven

Product Innovation∗

Christian Gillitzer

Reserve Bank of Australia, Sydney NSW 2000, Australia

gillitzerc@rba.gov.au

Henrik Jacobsen Kleven

London School of Economics and Political Science, London WC2A 2AE, UK

h.j.kleven@lse.ac.uk

Joel Slemrod

University of Michigan, Ann Arbor, MI 48109, USA

jslemrod@umich.edu

Abstract

Real-world tax legislation assigns goods to different categories of tax rates 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 taxation in the language of characteristics,

and we show how to optimally draw lines that delineate tax-rate regimes. Such lines are

associated with notches in tax liability as a function of characteristics, creating incentives

to introduce goods with new combinations of characteristics in order to reduce tax liability.

With a restricted set of tax instruments, such notches are in general part of the second-best

optimal tax system.

Keywords: Notches; tax design

JEL classification:H21

I. Introduction

Optimal tax theory in general prescribes different tax rates on each com-

modity, but in practice consumption tax systems feature a small number

of distinct rates. A non-capricious commodity tax system must have pro-

cedures for distinguishing among goods subject to the different tax rates.

Real-world tax systems do that by appealing to the characteristics of the

∗We thank Alan Auerbach, Tim Besley, Robin Boadway, Peter Fredriksson, Louis Kaplow,

Wojciech Kopczuk, Dan Shaviro, David Weisbach, Shlomo Yitzhaki, and anonymous referees

for helpful comments. We also thank Yulia Paramonova for valuable research assistance. C.

Gillitzer adds the disclaimer that the opinions expressed should not be attributed to the

Reserve Bank of Australia.

CThe editors of The Scandinavian Journal of Economics 2015.

C. Gillitzer, H. J. Kleven, and J. Slemrod 241

commodities. For example, US states retail sales taxes often exempt food

purchases but not restaurant meals, requiring the tax code to draw a line

between the two categories. This is done by appealing to a set of char-

acteristics of a restaurant meal, and the line can be fine – such as when

grocery stores sell pre-prepared meals that might or might not be eaten

on the premises, or when stores set up in-store salad bars. The retail sales

tax in the Canadian province of Ontario exempts basic food items such

as flour but applies to other processed foods such as chocolate bars. This

requires lines to be drawn, including one that subjects to tax biscuits or

wafers specifically packaged and marketed to compete with chocolate bars.

Several European countries provide a subsidy for certain kinds of consumer

services (e.g., cleaning, gardening, and house repair) based on a Ramsey-

type justification that such services compete with untaxed home production.

This requires the classification of services eligible for the subsidy based

on observable characteristics.

Although line drawing is a ubiquitous issue in real-world tax systems and

a pervasive point of contention among tax lawyers, there is little economic

analysis of the issue. We note that a “line” shares many attributes of a

“notch” in tax schedules, which refers to a discontinuity in the function of

how tax liability relates to the tax base, and which has attracted much recent

attention among economists as a means of identifying behavioral response

elasticities (e.g., Kleven and Waseem, 2013). Indeed, a line creates a notch

in characteristics space, because the tax liability changes discontinuously

when the characteristics vector of a good crosses the statutory line. As

long as a continuum of tax rates is administratively infeasible, notches

in characteristic space are an unavoidable feature of tax systems, not an

idiosyncrasy.

The prominent role of characteristics in commodity tax systems is the

result of several factors. First, using observable characteristics is a natural

and intuitive way to distinguish among different goods, or different groups

of goods, and to assign them to tax-rate categories. The alternative that

the theory of optimal commodity taxation implies (i.e., classifying goods

according to compensated elasticities) is infeasible, both because these elas-

ticities are notoriously difficult to estimate precisely and because this type

of rule would not be intuitive to policymakers, voters, or consumers in

the way that characteristics-based rules are. Second, a shared characteristic

plausibly signals something about the relative substitutability of the goods,

and so it might serve as a more readily measurable indicator of the ideal,

but not observable, determinants of the appropriate tax rate.1Third, mod-

ern economies produce a vast amount of different goods, and the set of

1Kleven and Slemrod (2009) address this problem with a completely distinct modeling

approach. They formalize the relationship between characteristics, substitutability, and optimal

CThe editors of The Scandinavian Journal of Economics 2015.