Perfect Taxation with Imperfect Competition

This paper analyzes features of perfect taxation – also known as optimal taxation – when one or more private markets is imperfectly competitive. Governments with perfect information and access to lump-sum taxes can provide corrective subsidies that render outcomes efficient in the presence of imperfect competition. Relaxing either of these two conditions removes the government’s ability to support efficient resource allocation and changes the perfect policy response. When governments cannot use lump-sum taxes, perfect tax policies represent compromises between the benefits of subsidizing output in the imperfectly competitive sectors of the economy and the costs of imposing higher taxes elsewhere. This tradeoff is formally identical for ad valorem and specific taxes, even though ad valorem taxation is welfare superior to specific taxation in the presence of imperfect competition. When governments have uncertain knowledge of the degree of competition in product markets, perfect corrective tax policy is generally of smaller magnitude than that when the degree of competition is known with certainty. JEL Classification: H21, D43. Alan J. Auerbach James R. Hines Jr. Department of Economics Office of Tax Policy Research 549 Evans Hall University of Michigan Business School University of California 701 Tappan Street Berkeley, CA 94720-3880 Ann Arbor, MI 48109-1234 [email protected] [email protected]