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Specific taxation, asymmetric costs, and endogenous quality

Philipp J. H. Schröder and Allan Sørensen ()

Journal of Public Economic Theory, 2021, vol. 23, issue 5, 1022-1051

Abstract: This paper shows how a specific tax—in contrast to an ad valorem tax—alters industry structure and firm‐level performance in a monopolistic competition framework, where firms chose product quality endogenously and differ exogenously in productivity (i.e., marginal production efficiency). Industry equilibrium mechanisms and selection based on productivity play a significant role: A specific tax shifts market shares and profits toward firms with costs and prices above the industry average at the expense of low‐cost firms. This reallocation of market shares releases a novel scale effect such that low‐cost firms may quality downgrade, while high‐cost firms always quality upgrade. There exists a parameter subspace, where this combines to a decrease on average quality for the industry. In comparison: An ad valorem tax only reduces the number of firms/varieties in the industry due to demand absorption, but affects neither firm‐level performance nor industry structure.

Date: 2021
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