Unit vs. Ad Valorem Taxes under Revenue Maximization

Abstract

We compare unit and ad valorem commodity tax regimes under the "Leviathan hypothesis" that the government seeks to maximize tax revenue. We show that the ad valorem tax regime welfare-dominates the unit tax regime if and only if the economy exhibits "ad valorem under-shifting" in response to a change in the tax level. Under Cournot competition, the level of shifting depends entirely on whether demand is not too convex so that elasticity of demand is increasing in price. In a more general framework, with differentiated goods, the threshold level of convexity such that unit taxes welfare dominate ad valorem ones can be lower.

Keywords: Commodity Taxation, Unit Tax, Ad Valorem Tax, Tax Shifting, Pass-Through, Revenue-Maximizing Government, Imperfect Competition

JEL Classification: D40, H20, H21, H71