Direct versus indirect taxation: The design of the tax structure revisited

This article studies the optimal direct/indirect tax mix problem when indiv iduals differ in several unobservable characteristics (productivity and end owments). It presents general expressions for the optimal commodity tax rat es and proves that contrary to Atkinson and Stiglitz's (1976) result, diffe rential commodity taxation remains a useful instrument of tax policy even i f preferences are separable between labor and produced goods. When cross su bstitution effects are zero, the expressions resemble traditional many hous eholds Ramsey rules. In a Cobb-Douglas illustration, where endowments diffe r only in good 1 (interpreted as "wealth"), the tax on good 2 Provides an i ndirect way to tax the unobservable wealth.