Taxing a Commodity with and Without Revenue Neutrality: A Calibrated Theoretical Consumer Equilibrium Model (Report‪)‬

Introduction The use of a tax instrument to discourage the consumption of a commodity that generates negative externalities has a long history in the economics literature. The externalities might be in the form of health damage and higher health care costs (taxation of tobacco products), traffic congestion (toll road fees), or environmental degradation (taxation according to carbon content), for examples. A variant on the straightforward taxation of a designated commodity involves the imposition of a revenue neutrality constraint--a requirement for an offset somewhere else in the tax system so as to leave public revenue unchanged. But a revenue neutrality constraint alters the situation because it changes the rate of taxation necessary to achieve any given consumption reduction target. Just how much it changes that rate depends heavily on the demand and supply elasticities of the targeted commodity and the cross-elasticities with other commodities in the consumer budget. We explore the relationships among the tax rate, the elasticities, and the effects of revenue neutrality by calibrating a theoretical model of consumer market equilibrium and then recalibrating the model so as to span a wide range of parameter configurations. For each parameter configuration, we solve the model assuming alternative policy scenarios.