Many developing countries simultaneously tax commodities and subsidize them up to a quota level through ration shops. This particular combination of taxes and subsidies
plays an important role in the public budgets of developing countries; India spends 1 GDP point on its ration shop system and levies more than 60% of its revenues through commodity taxes. This paper first studies under what conditions this tax schedule - de
facto convex commodity taxes - is welfare improving compared to standard linear taxes once we take into account the relevant characteristics of developing countries. These are i)
limited government capacity to observe household incomes and ii) market fragmentation. I find that an inequality-averse government would set convex taxes on a wide range of
goods to redistribute and to partially insure households against price risk. Welfare gains to introducing convex taxes are highest for normal goods that most poor households consume.
I then take the model to Indian data and find that combining ration shops and commodity taxes is welfare improving for rice, wheat and kerosene, but not for sugar. Setting convex
taxes on other goods not currently in the Indian ration shop system would not help the government redistribute across households but would yield small insurance gains.