Abstract
This paper compares ad-valorem and specific taxation in models where a representative consumer with an exogenous income has both a quality and a quantity choice under perfect competition. In the setting, while ad-valorem tax causes income effect only, specific tax causes both income effect and substitution effect. Therefore, ad-valorem tax decreases consumer demand for both quality and quantity; on the other hand, specific tax decreases consumer demand for quantity. However, the sign of consumer demand for quality is ambiguous and is determined by the curvature of marginal utility on quantity. Additionally, using a constant elasticity of substitution (CES) utility function and a linear price function, we show that ad-valorem tax is superior to specific tax except for the Leontief preference under which the two forms of commodity taxes generate the same tax revenue. The substitution effect caused by specific tax disappears if the elasticity of substitution converges to zero.
Highlights
In the field of public finance, there are many studies that compare social welfare under ad-valorem and specific taxation
Assuming that a price function is linear and individual preference is expressed by the constant elasticity of the substitution (CES) utility function, we analytically show that an ad-valorem tax is superior to a specific tax in the presence of a substitution effect, if any
Contrary to most papers investigating such a comparison of social welfare under imperfect competition, we allow for quality choice as well as a competitive environment
Summary
In the field of public finance, there are many studies that compare social welfare under ad-valorem and specific taxation. These studies ignore the impact of the tax structure on the product quality selected by firms If both forms of taxation affect the quality, wholly specific taxation can be optimal under perfect competition (see [8] [9] and [10]). The study investigates the two forms of commodity taxation under nonlinear labor income taxes when individuals have different productivity, and there is asymmetric information between the policymaker and taxpayers with respect to individuals’ productivity. Both consumption taxes play a crucial role in relaxing incentive constraints, such taxes are necessary to implement the second-best allocation, which contradicts the canonical results provided by [12].
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