Ad Valorem Versus Per Unit Taxation: a Perspective from Price Signaling

This paper compares ad valorem and per unit taxation in the context of price signaling. In the model, a taxation designer chooses between ad valorem and per unit taxation to maximize tax revenues, and a monopoly firm, whose product quality can be either high or low, uses price as a quality signal. The analysis shows that, compared to per unit taxation, ad valorem taxation raises the low-quality firm’s mimicking cost and lowers the high-quality firm’s signaling cost. This leads to higher transaction volumes and tax revenues.