Consumption indivisibility and the optimal tax mix

This paper reexamines optimal commodity and income taxation with consumption indivisibility. We show that, in the presence of indivisible-good consumption, the Atkinson-Stiglitz theorem on the uselessness of commodity taxation fails. Without a distortion on consumption, the optimal commodity tax on indivisible goods acts as a differential lump-sum tax to engage in income redistribution and achieve the social optimum. The optimal tax rate for a specific divisible good is higher (lower) if the divisible good and the indivisible good are substitutes (complements). Differential commodity taxation can always improve welfare under a simple linear income tax system.