The Welfare Comparison of Ad-Valorem Tax and Specific Tax with Both Quality and Quantity Choice of a Consumer

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.

Specific taxation, asymmetric costs, and endogenous quality

“…Rojas and Shi (2011) show by simulation that the effect of a specific tax on the relative price, relative quantity, and relative advertising across quality levels is ambiguous in an oligopoly setting with an exogenous number of multiproduct firms competing in prices and advertisement (quality is fixed). Even for competitive markets the equivalence of specific and ad valorem taxation vanishes when quality is endogenous: Liu (2003) shows that specific taxation results in higher quality than ad valorem taxation under three stylized preference structures, Delipalla and Keen (2006) derive the optimal mix of specific and ad valorem taxation, and Obara and Tsugawa (2017) compare the tax instruments when consumers decide on quality as well as quantity. The present paper contributes to the public economics literature by exploring the effects of specific (and ad valorem) taxation on industry structure and firm‐level variables in a tractable imperfect competition setting with asymmetric costs, endogenous quality choice, and endogenous entry/exit.…”