Competition and Welfare Effects of Differentiated Taxation: Evidence from the Irish Automobile Market

Abstract

We develop a theoretical model to study the effects of an ad valorem taxation regime differentiated according to product characteristics (quality) within an imperfectly competitive market. Then to test our theoretical prediction we use yearly data from the Irish automobile market during the period 2004-2008, and assess the implications of this type of regime on competition and consumer welfare. By emphasizing the role played by the own- versus the cross-price elasticity, we are able to capture an important dimension in which the strategic interactions among firms play out in response to a tax change. The welfare effects of a taxation system that is tailored to product attributes are not trivial. Using a counterfactual analysis based on a homogenous tax rate, we conclude that a differentiated taxation regime benefits consumers who value quality more, while it penalizes those more sensitive to price increments. Our results confirm the extended Ramsey rule predictions. Furthermore, a symmetric increase in taxation narrows the price gap induced by asymmetries in quality and productivity, if the tax regime is homogenous, and widens it, if the tax regime is differentiated.

Keywords: ad valorem taxation, cross-tax elasticity, differentiated and homogeneous taxation, differentiated products, imperfect price competition, welfare analysis

JEL Classification: H22, L11, L13, L62