Berkeley Program in Law and Economics

This paper considers the arguments regarding the choice between an ideal income tax and an ideal consumption tax, focusing on an argument first made by Atkinson and Stiglitz regarding neutral taxation of commodities. This argument shows that, under its assumptions, a properly designed consumption tax is Pareto superior to an income tax: it is more efficient, more redistributive, or both. The paper illustrates the Atkinson Stiglitz argument using the simple case where investments produce risk-free returns and individuals vary by their ability. It then considers more complex cases, such as risky returns, inherited wealth, heterogeneous savings rates, and the possibility of additional returns to savings, such as power, prestige, and security. Finally, it examines qualifications to the argument and circumstances under which an optimal tax might provide for some taxation of interest income.