Comparing specific and ad valorem taxes under price-inelastic demand with quality differentiation

Kuang Cheng Andy Wang, Wen Jung Liang*, Ping Yao Chou

*Corresponding author for this work

Research output: Contribution to journalJournal Article peer-review

Abstract

We examine the superiority of a specific tax and an ad valorem tax in a fully covered model with vertical differentiation, in which the demand elasticities of the products are inelastic. By focusing on the influences of vertical differentiation and inelastic demand, we show that a specific tax is superior to an ad valorem tax in the short run, when the marginal cost of the high-quality product is relatively low or is relatively high and the ad valorem tax rate is high. We also show that a specific tax may not only be welfare superior to, but may also Pareto dominate an ad valorem tax in the long run, when the ad valorem tax rate is high. These two results imply that the government should impose a specific tax on products with price-inelastic demand if the tax revenue requirement is high. Besides, we obtain that the main result remains unchanged when one of the firms is a foreign firm, and that the firms’ equilibrium quality levels and outputs will change to become identical to welfare-maximizing levels regardless of the tax schemes, when one of the firms is a public firm.

Original languageEnglish
Pages (from-to)183-216
Number of pages34
JournalAcademia Economic Papers
Volume48
Issue number2
StatePublished - 06 2020

Bibliographical note

Publisher Copyright:
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Keywords

  • Ad valorem tax
  • Price-inelastic demand
  • Quality differentiation
  • Specific tax

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