Double Marginalization Distortions

Double Marginalization occurs when two firms within a supply chain "compete" for the value the chain creates. The upstream firm's margin becomes part of the marginal cost incurred downstream which then gets magnified by the downstream firm setting its margin. Prices are too high, output is too low, and further investment is less profitable. If the firms were to integrate, they would "marginalize" only once, leading to increases in consumer surplus and profits to all parties.

An analogous effect occurs  when a turnover tax becomes a value added tax (VAT). A turnover tax, or sales tax, is a margin on all firms within a supply chain while a VAT represents a single margin. Firms in a supply chain tend to merge simply to avoid multiple turnover taxes. In "How Distortive are Turnover Taxes? Evidence from Replacing Turnover Tax with VAT," Xing, Bilicka and Hou investigate what happened in China when taxation transitioned from a turnover tax to a VAT. Without the motive to avoid double marginalization, firms can now outsource more if outsourcing is more efficient. As predicted:

The reform increased sales, R&D investment, and employment for affected service firms, which is primarily driven by outsourcing from downstream manufacturing firms. We document that smaller and less innovative manufacturing firms outsource more, and reallocation increases the quality of innovation for affected service firms.