Ad valorem taxation on intermediate goods in oligopoly

The paper compares the efficiency of value added taxation (VAT), in which intermediate goods are not taxed, with that of cascade taxation, in which they are, when levied on imperfectly-competitive vertically-related industries. One type of commodity taxation is not always superior to the other in terms of welfare. Indeed, when intermediate-goods have close substitutes, VAT is the optimal commodity tax system. But when input substitutability is weak or absent and input producers have market power, they should be taxed. In fact, in the absence of lump sum taxes and with no input substitutability, it is optimal to tax, not to subsidize, the most monopolistic industry. True cascading, in which both upstream and downstream industries are taxed, is thus better than VAT when, besides no input substitutability and both intermediate and final good producers with market power, the needed revenue requirement is not small. We therefore submit a rationale for the coexistence of VAT and cascade taxation.