Effects of Externality-Corrective Taxation on the Extent of the Market and Network Size of Division of Labor

Applying the inframarginal analysis of specialization and the effects of external costs in production and their control through taxation, this paper shows that, on top of the allocational inefficiency on the input and/or output mix caused and alleviated, there is the organizational inefficiency on the level of division of labor and extent of the market. External costs may lead to either too high or too low a level of division of labor or a mixture of efficient and inefficient structures. Low-cost taxes directly on the variables causing external costs may remove the inefficiency but may not be feasible, as, e.g., home production may be difficult to observe. Sales taxes/subsidies are completely useless as the general-equilibrium adjustments yields zero effects. A tax cum income transfer scheme may be effective in alleviating the allocational and organizational inefficiencies within certain ranges of parametric values. With the other range of parameter values, the optimum tax rate is 0 since a positive Pigovian tax generates organization distortion that outweighs corrective effect of allocative distortion.