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

57 Pages Posted: 25 May 2021

See all articles by Kory Kroft

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

Matthew Notowidigdo

University of Chicago - Booth School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: May 24, 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.

JEL Classification: H20,H22,H71

Suggested Citation

Kroft, Kory and P. Laliberté, Jean-William and Leal Vizcaíno, René and Notowidigdo, Matthew, A Welfare Analysis of Tax Structures with Love-of-Variety Preferences (May 24, 2021). University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2021-63, Available at SSRN: https://ssrn.com/abstract=3852180 or http://dx.doi.org/10.2139/ssrn.3852180

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

Matthew Notowidigdo (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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