Tax Base Diversification as an Enforcement Tool

Abstract We examine when it is optimal to employ sales or VAT-type taxes as complements to a labor income tax. We find a Ramsey-type result in which each tax instrument should be imposed in inverse proportion to the combined elasticity of real and avoidance responses to the respective tax. Contrary to some prior results, we find that sales-type taxes are optimally non-zero across a variety of settings, and in particular when the (weighted) elasticity of taxable income with respect to the wage tax is greater than the cross-elasticity of taxable income with respect to the sales tax. We argue this parameter should be of key interest for empirical research, and conduct some exploratory studies in which we estimate it using changes in California local sales taxes and EU VAT rates. Our estimates generally suggest non-zero consumption taxes would be efficient.