Optimal Indirect Taxes and Subsidies under Imperfect Competition

This paper considers optimal indirect taxes and subsidies in an economy with imperfect competition. All commodities are taxable. A beneficent government chooses indirect tax and subsidy rates to maximize consumer utility, conditional on raising certain tax revenue. This paper finds that the government's optimal taxes and subsidies should equalize the after-tax Lerner indexes (or price-to-marginal-cost ratios) of all commodities. The proposed tax rule eliminates the price distortions caused by market power. It thus results in welfare gain rather than deadweight loss.