2.

Optimal commodity taxation

This chapter deals with the rst fundamental issue in optimal tax policy: the choice of an optimal tax structure (i.e. optimal `relative taxes' imposed on dierent tax bases). Redistributive concerns can be incorporated into this model (see section 2.2), but they are not central to the issue. The focus is on allocative (second-best) eciency. The chapter introduces the basic procedure of solving optimal tax problems. In the rst stage, the government sets the (optimal) vector of taxes, to which individuals adjust (optimally) in the second stage. This problem is solved by backward induction, thus giving the subgameperfect solution to the optimal tax problem. In the second stage, individuals treat the vector of taxes parametrically and choose demands as a function of the tax

rates set by governments (which enter as part of the consumer price vector). In the rst stage governments choose the vector of taxes so as to maximize the welfare of a representative consumer (in the simplest case without distributional concerns), anticipating correctly the optimal adjustment of consumers.