Market Substitution and the Pareto Dominance of Ad Valorem Taxation

Based on product homogeneity and Cournot competition, past literature has uniformly shown that ad valorem taxation welfare dominates unit taxation in noncompetitive markets. This paper allows goods in a market to be heterogeneous and firms to be Bertrand competing. We confirm the short‐run findings of others that consumer welfare and overall welfare are always higher under ad valorem taxation. However, ad valorem taxation generates larger profits (hence Pareto dominates) only when market demand is elastic, perhaps explaining the persistence of unit taxation in markets with inelastic demand. The effects on ad valorem Pareto dominance of within‐ and between‐market substitutability, number of firms in the taxed market, and the level of taxation are also investigated. In the long run, an equal‐revenue substitution of ad valorem taxation for unit taxation reduces consumer price, which is welfare improving, but also reduces variety when market demand is elastic, which is welfare decreasing. Nonetheless, ad valorem welfare dominance still holds in the long run.