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Ad valorem versus unit taxes: Monopolistic competition, heterogeneous firms, and intra-industry reallocations

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Real-world industries are composed from heterogeneous firms and substantial
intra-industry reallocations take place, i.e. high productivity firms
squeeze out low productivity firms. Previous tax-tool comparisons have
not included these central forces of industry structure. This paper examines
a general equilibrium monopolistic competition model with heterogeneous
firms and intra-industry reallocations. We show that the welfare
superiority of ad valorem over unit taxes under imperfect competition is
not only preserved but amplified. The additional difference between the
tools arises because unit taxes distort relative prices, which in turn reduces
average industry productivity through reallocations (the survival and increased
market share of lower productivity firms). Importantly, numerical
solutions of the model reveal that the relative welfare loss from using the
unit tax increases dramatically in the degree of firm heterogeneity.
Original languageEnglish
Place of publicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages18
Publication statusPublished - 2010

    Research areas

  • unit tax, ad valorem tax, welfare, intra-industry reallocation, monopolistic competition, heterogenous firms

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