Uncertainty and optimal taxation: In defense of commodity taxes

This paper re-examines the theory of optimal commodity taxation in the presence of a linear income tax, under wage uncertainty. There are two categories of goods: the consumption levels in one group are committed to before the resolution of uncertainty and those of the other after. The paper (i) characterizes the structure of the optimal commodity taxes in view of the insurance they provide against random wage movements, (ii) proves that optimal taxation requires a mix of differential commodity taxes and a uniform lump-sum tax, and (iii) demonstrates that the post-uncertainty goods should face a positive tax rate which is higher than the tax rate on the pre-committed goods.