Optimal Commodity Taxation With Costly Noncompliance

Abstract

Because noncompliance has efficiency and equity implications, it should be a concern in the design of the commodity tax structure. This article derives the optimal commodity tax conditions and modifications to their standard interpretation when consumers engage in costly border crossing to evade local taxes. It presents a model of costly noncompliance behavior and a modified version of Roy's theorem describ ing the effect on indirect utility of a tax change when cross-border shopping occurs. This modified Roy's theorem permits the inverse elasticity rule, proportionate shrinkage rule, and covariance interpretation of the optimal tax conditions to be adapted to the case of costly noncompliance.