Informality, Consumption Taxes, and Redistribution

Pierre Bachas (World Bank)

Abstract:

We study how the presence of large informal sectors in developing countries impacts the distributional properties of consumption taxes. We assemble a dataset of household expenditure using micro-data from 25 countries at different levels of economic development. Using the place of purchase to proxy for informal consumption, we document a large negative relation between informal consumption shares and households' total expenditure. This implies that consumption taxes are de-facto progressive: households in the top decile pay 70% more taxes as a share of expenditure than households in the bottom decile. We build a model of optimal commodity taxation in the presence of informal consumption. We find that optimal tax rates are higher, and less differentiated across products the steeper the relation between informal consumption and total expenditure.