Taxation, imperfect competition, and discontinuities

Abstract

Most work on taxation assumes that market adjustments to taxation will be small and continuous and so analyzes the effects of taxation using standard marginal methods. However, the world often changes in large and discontinuous ways. This paper looks at the effects of taxation when discontinuities in market adjustments are allowed because market structure is determined endogenously by the discrete entry and exit decisions of firms. The results indicate that the potential for discontinuities generates tax effects that are considerably different from those that emerge when adjustments are small and continuous. With discontinuities, taxes can have large and discrete effects, for example, by increasing prices far in excess of the tax itself or by changing utility in a highly nonmarginal way. Of more significance, with discontinuities taxes can actually increase welfare even when they lessen competition and raise prices. Taxes can also have markedly different effects on the income and welfare of different groups. Consumers are always made worse off by a tax, but a tax may be supported by the firms in an industry if the tax limits entry and thereby increases firm profits.