Optimal grouping of commodities for indirect taxation

Indirect taxes contribute to a sizeable part of government revenues around the world. Typically there are few different tax rates, and the goods are partitioned into classes associated with each rate. The present paper studies how to group the goods in these few classes. We take as given the number of tax rates and study the optimal aggregation (or classification) of commodities of the fiscal authority in a second best setup. The results are illustrated on data from the United Kingdom.