A Welfare Analysis of Tax Structures with Love-of-variety Preferences

55 Pages Posted: 27 Apr 2021

See all articles by Matthew Notowidigdo

Matthew Notowidigdo

University of Chicago - Booth School of Business

Kory Kroft

University of Toronto

Jean-William Laliberté

University of Calgary - Department of Economics

René Leal Vizcaíno

Northwestern University, Department of Economics; Banco de Mexico

Multiple version iconThere are 2 versions of this paper

Date Written: April 2021

Abstract

This paper reassesses the general trade-off between ad valorem and specific taxation
using an economic model that features love-of-variety preferences and encompasses a
wide range of market conduct – including both quantity and price competition – while
allowing for firm entry and exit. We derive formulas for efficiency and incidence of
both types of taxes that depend on the responsiveness of product variety to taxes and
the effect of a change in product variety on consumer surplus. We use our formulas to
derive a desirability condition for when ad valorem taxes are more efficient than specific
taxes and a condition for when ad valorem taxes lead to greater pass-through than
specific taxes. We identify and estimate the model parameters using a quasi-experimental
“county border pair” research design that uses state-level and county-level variation in
sales taxes combined with detailed scanner data covering grocery stores in the U.S. Our
empirical results indicate that sales taxes are slightly overshifted onto consumer prices,
have a large effect on quantity demanded, and have a more modest effect on the variety of
products available to consumers. Using the estimated parameters, we recover consumers’
love-of-variety, infer whether or not product variety is socially optimal (at current tax
rates), and implement our desirability condition. We find that specific taxes are more
efficient at the margin than ad valorem taxes given the estimated love-of-variety. This
suggests that policymakers should consider using specific taxes and tariffs in markets
with substantial product differentiation.

Keywords: ad valorem taxes, specific taxes, pass-through, love-of-variety preferences

JEL Classification: H21, H22

Suggested Citation

Notowidigdo, Matthew and Kroft, Kory and P. Laliberté, Jean-William and Leal Vizcaíno, René, A Welfare Analysis of Tax Structures with Love-of-variety Preferences (April 2021). Available at SSRN: https://ssrn.com/abstract=3834655 or http://dx.doi.org/10.2139/ssrn.3834655

Matthew Notowidigdo (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Kory Kroft

University of Toronto ( email )

Toronto, Ontario M5S 3G8
Canada

Jean-William P. Laliberté

University of Calgary - Department of Economics ( email )

2500 University Dr. N.W.
Calgary, Albetra T2N 1N4
Canada

René Leal Vizcaíno

Northwestern University, Department of Economics ( email )

Evanston, IL
United States

Banco de Mexico ( email )

Ave Cinco e Mayo 1
Col. Centro
Mexico City, Mexico DF 06059
Mexico

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