The E¢ ciency Comparison of Taxes under Monopolistic Competition with Heterogenous Firms and Variable Markups

This paper compares the e¢ ciency implications of aggregate output equivalent unit versus advalorem tax regimes when monopolistically competitive …rms produce di¤erentiated products with either homogenous or heterogenous costs. The model allows for …rms to price at a variable markup over marginal cost. In line with most prior …ndings the superiority of ad-valorem tax continues to hold when …rms have homogenous costs. However, I …nd that a unit tax becomes more e¢ cient when …rms have heterogenous costs and unit tax is relatively high. The model generates both the selection of …rms and reallocation of resources, in addition to the well-documented e¤ects of tax regimes on …rms’output and pricing decisions. Furthermore, these two tax regimes have di¤erential e¤ects on mark-up distributions: an ad-valorem tax distorts the mark-up distribution of …rms in favor of more productive …rms. The aggregate productivity is therefore higher compared to an output equivalent unit tax. A more productive market with lower prices ampli…es the superiority of the ad-valorem tax at lower revenue requirements. However, I …nd that when the unit tax is relatively high, the excessive exit rate under an ad-valorem tax regime overturns the welfare superiority argument in favor of a unit tax regime. JEL Classi…cations: L11 H21 H25