By Conny Olovsson
Optimal taxes for Europe and the U.S. are derived in a realistically calibrated model in which agents buy consumption goods and services and use home capital and labor to produce household services. The optimal tax rate on services is substantially lower than the tax rate on goods. Specifically, the planner cannot tax home production directly and instead lowers the tax rate on market services to increase the relative price of home production. The optimal tax rate on the return to home capital is strictly positive and the welfare gains from switching to optimal taxes are large.
This paper makes a very simple, but often neglected point. If market services and home produced goods (say, restaurant meals and home-cooked meals) are substitutes, one needs to tax market services less than other goods. The intuition is simple: you want to avoid flight to the home production sector that cannot be taxed. Were they complements, then the taxes should be higher, so as to tax the otherwise untaxable. The paper quantifies all this and shows this is really important, especially once you factor in that households react to the tax environment.