Commodity Taxation as Insurance Against Price Risk

The paper shows how commodity taxes can provide insurance to consumers when the producer price is volatile. Specific and ad valorem taxes have differing roles. The optimal specific tax is positive when demand has some elasticity. The optimal ad valorem rate is zero when demand is unit-elastic, negative when demand is inelastic and positive for elastic demand. When both types of taxes are used in general the specific tax is positive and the ad valorem rate is negative. The model also applies to the problem in public utility regulation of determining how retail prices should move with wholesale or fuel prices.