Efficiency and Incidence of Taxation with Free Entry and Love-of-Variety Preferences

Abstract

This paper develops a theory of commodity taxation with love-of-variety preferences and endogenous firm entry and exit. We consider a framework that encompasses a wide range of firm conduct and derive formulas for efficiency and pass-through of specific and ad valorem taxes. These formulas unify existing canonical ones in the literature and lead to novel economic insights for both welfare and incidence. We use them to derive a desirability condition for when ad valorem taxation is more efficient than specific taxation and a condition for when ad valorem taxation leads to greater pass-through than specific taxation. Finally, we consider an empirical application that illustrates how to estimate the key parameters of the tax formulas in a theoretically consistent way. Our results indicate that specific taxes are more efficient at the margin than ad valorem taxes and that product variety is below the socially optimal level.

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