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

This paper reassesses the general trade-off between ad valorem and specific taxationusing an economic model that features love-of-variety preferences and encompasses awide range of market conduct – including both quantity and price competition – whileallowing for firm entry and exit. We derive formulas for efficiency and incidence ofboth types of taxes that depend on the responsiveness of product variety to taxes andthe effect of a change in product variety on consumer surplus. We use our formulas toderive a desirability condition for when ad valorem taxes are more efficient than specifictaxes and a condition for when ad valorem taxes lead to greater pass-through thanspecific 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 insales taxes combined with detailed scanner data covering grocery stores in the U.S. Ourempirical 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 ofproducts available to consumers. Using the estimated parameters, we recover consumers’love-of-variety, infer whether or not product variety is socially optimal (at current taxrates), and implement our desirability condition. We find that specific taxes are moreefficient at the margin than ad valorem taxes given the estimated love-of-variety. Thissuggests that policymakers should consider using specific taxes and tariffs in marketswith substantial product differentiation