Rents, Regulation, and Indirect Tax Design

This paper discusses the implications of rents and regulations which support them for the design of indirect taxes such as VATS. Intuition suggests high tax rates on industries or products with rents; but we argue that whether rents are natural (due to fixed factors) or market structure related (monopolistic) makes a large difference. In the latter case, a high tax may induce adverse behavioral changes. We develop a general equilibrium tax model based on Canadian data and which incorporates both types of rent, and we use numerical simulation analysis to explore the implications of different types of rents for the design of indirect taxes. Our results suggest that the ways in which taxes should deviate from uniformity depends crucially on the mechanisms that generate rents. They also imply that a broadly based uniform tax will typically not be the optimal choice for economies where rents represent a significant share of value added, even when preferences are homothetic. Finally, they demonstrate that the presence of rents substantially affects measures of the social costs of indirect taxes, both in total and at the margin, and in both directions depending upon the nature of the rents involved.