Tax Reform in Monopolistic Competition with Increasing Preferences for Variety

Nearly all comparisons of ad valorem and unit taxes follow Suits and Musgrave in demonstrating the welfare dominance of ad valorem taxes. We study unit and ad valorem taxes in a monopolistic competition model where, as is the normal case, consumers have increasing preferences for variety. We show that introducing more unit taxation and less ad valorem taxation can increase consumer welfare and the tax revenue when consumers’ utility depends on both quantity and variety. To understand this, notice that more unit taxation, under a price-neutral criterion, increases tax revenue. That is, aggregate output increases after the tax change. On the other hand, we show that aggregate output goes up because variety goes up, which explains that decreased product variety cannot offset the favorable change in aggregate output.