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Consumption taxes in monopolistic competition: a comment

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Abstract

We show that an ad valorem tax is better than an equal-revenue unit tax when consumers spend some fixed proportion of income on taxed goods, when firms use constant mark-up pricing, and entry and exit drive per-firm profit to zero. These key assumptions implies that ad valorem taxes are superior in oligopoly as well as monopolistic competition, showing that earlier results on taxes in monopolistic competition (Schröder in J Econ 83(3):281–292, 2004) are not due to the mode of competition, but rather are due to the functional forms used.

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Notes

  1. It must be stressed that Schröder (2004) suggests analysing unit versus ad valorem taxes with other specifications of the Dixit–Stiglitz model. The present note makes it clear why this is worthwhile, in particular since the model is used in subsequent papers, cf. note 2.

  2. Subsequent use of the standard Dixit–Stiglitz model on unit versus ad valorem taxes with heterogeneous firms (Schröder and Sørensen 2010) and on corrective taxes (Droge and Schröder 2009) also relies on constant mark-up pricing. Reinhorn (2012) discusses optimal corrective taxation in multi-sector monopolistic competition without making assumptions about constant mark-up pricing but does not address the question of tool ranking.

  3. The following description is brief. It follows Schröder (2004) and the reader is referred hereto for details.

  4. A number of subsequent analyses confirm that ad valorem taxes are better than unit taxes in oligopoly. Related most closely to our note is a result due by Hamilton (2009) He shows that unit taxes are preferable in the non-normal case of decreasing preference for variety (variety matters less when output increases). In the standard Dixit–Stiglitz model preferences for variety is constant.

  5. For a discussion of monopolistic competition models allowing some firm positive profits see Benassy (1991, Sect. 5.6).

  6. To work out the full consequences of changes in the tax policy we have to take into account the effect on the number of firms also. This is beyond the scope of the present note. Notice that Anderson et al. (2001b) show that unit taxes can be welfare superior to unit taxes in differentiated oligopoly with free entry.

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  1. Statsbiblioteket, Universitetsparken, 8000 , Aarhus C, Denmark

    Henrik Vetter

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  1. Henrik Vetter
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Vetter, H. Consumption taxes in monopolistic competition: a comment. J Econ 110, 287–295 (2013). https://doi.org/10.1007/s00712-012-0320-6

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