The Comparison of ad Valorem and Specific Taxation under Uncertainty

• Author: KONSTANTINOS SERFES,CHRISTOS KOTSOGIANNIS
• Published date: 01 February 2014
• DOI: http://doi.org/10.1111/jpet.12059
• Date: 01 February 2014

THE COMPARISON OF AD VALOREM AND SPECIFIC

TAXATION UNDER UNCERTAINTY

CHRISTOS KOTSOGIANNIS

University of Exeter Business School

KONSTANTINOS SERFES

Drexel University

Abstract

The comparison between specific (per unit) and ad valorem

(percentage) taxation has been one of the oldest issues in

public finance. In Cournot markets, with deterministic costs

structures, conventional wisdom has it that ad valorem taxa-

tion tax-revenue dominates specific. It is shown that in the

presence of uncertainty, regarding firms’ cost structures,

and under reasonable conditions, the conventional wisdom

might not hold. The implication of this, from a policy per-

spective, is that the precise evaluation of the two types of tax-

ation requires an explicit consideration of cost uncertainty.

1. Introduction

Two fundamental considerations in the design of fiscal policy, and for the

success of fiscal reforms, are the stability, certainty, and predictability of tax

Christos Kotsogiannis, Department of Economics, University of Exeter Business School,

Streatham Court, Rennes Drive, Exeter EX4 4PU, England, UK, and CESIfo, Mu-

nich, Germany (c.kotsogiannis@exeter.ac.uk). Konstantinos Serfes, Department of Eco-

nomics, LeBow College of Business, Drexel University, Philadelphia, PA 19104, USA

(ks346@drexel.edu).

We thank a coeditor and two anonymous referees for many insightful comments. We

also thank Michael Keen and Markus Reisinger and seminar participants at Athens Uni-

versity of Economics and Business and conference participants at the 2011 American Eco-

nomic Association meeting in Denver for comments and advice. Any remaining errors are,

of course, ours. This research was initiated while Serfes was visiting the University of Exeter

Business School and completed while Kotsogiannis was visiting LeBow College of Business,

Drexel University. The hospitality of both institutions is gratefully acknowledged. Finan-

cial support from the Catalan Government Science Network (SGR2005-177 and XREPP)

and the Spanish Ministry of Education and Science Research Project (SEJ2006-4444) is

gratefully acknowledged (Kotsogiannis).

Received January 25, 2011; Accepted April 14, 2012.

C2013 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 16 (1), 2014, pp. 48–68.

48

The Comparison of ad Valorem and Specific Taxation 49

revenues1and the choice between specific and ad valorem taxes. The inter-

play between these two considerations—and in particular the role of uncer-

tainty in the comparison of specific and ad valorem taxes—is the focus of this

paper.

Uncertainty can arise from various sources but, arguably, a dominant

source relates to the volatility (and unpredictability) of firms’ input prices,

and so their production costs.2To illustrate the role of uncertainty in the wel-

fare comparison between ad valorem and specific taxation, the analysis makes

use of the standard Cournot model with incomplete information about own,

and also rivals’, production costs. This particular information structure intro-

duces two elements. First, the equilibrium output, and consequently price,

follows a distribution. Second, while both types of taxation affect the mean

of the distribution, only ad valorem taxation affects its dispersion (variance).

The consequence of this is that all key welfare measures, which depend

on the mean and the dispersion of the output distribution, differ in sign from

those obtained from the classical deterministic Cournot model. Arguably,

this has important implications, given that uncertainty is an inherent feature

of markets, from a policy perspective.

The comparison between specific (per unit) and ad valorem (percent-

age) taxation has been one of the oldest issues in public finance, going back

to Wicksell’s (1896/1959) conjecture that ad valorem taxes may have favor-

able efficiency properties relative to specific taxes in monopoly markets. This

conjecture has been formally demonstrated, within a monopoly framework,

by Suits and Musgrave (1953). Following the seminal contribution of Suits

and Musgrave (1953), a literature has emerged investigating the desirability

of one tax over the other under various market structures.3Predominantly,

most contributions, with notable exceptions to which we turn below, have

focused on deterministic environments.

The results obtained can be summarized as follows. Within the deter-

ministic model, for every specific tax one can find an ad valorem tax that

yields the same marginal cost and, hence, the same equilibrium output. This

implies that the two taxes are equivalent in terms of social welfare. Since

profits, as they are discounted by the ad valorem tax rate, are lower under

1Such issue has been a major concern for many developing countries (Keen 1998).

2As in sectors that are energy-intensive. Another example of an imperfectly competitive

market that is characterized by cost uncertainty is the tobacco industry. Cost uncertainty

here can be—and should be—broadly defined to include not only the uncertain quality of

tobacco leaves but also the costs associated with regulatory rules and legal threats (World

Bank 2003).

3Delipalla and Keen (1992), Skeath and Trandel(1994), and Blackorby and Murty (2007)

extended Suits and Musgrave (1953) to a homogeneous product symmetric Cournot–

Nash oligopoly market. Dierickx, Matutes, and Neven (1988) and Denicol´

o and Matteuzzi

(2000) impose asymmetric cost structures. Anderson, de Palma, and Kreider (2001a,b)

allow for differentiated products. Hamilton (2009) extends the analysis to multiproduct

transactions and Peitz and Reisinger (2009) to vertical oligopolies.