The present paper analyzes the impact of production taxes on economic efficiency when firms’ production is fragmented, contracts are incomplete and managers can choose either an integrated or an outsourced structure for their firm. Results indicate that a tax on production creates inefficiencies under outsourcing as it prevents managers to enhance coordination between their units. Integration instead implements full coordination which protects the firm against such ‘tax induced’ inefficiencies. Thus, any production tax that induces an organizational switch from integration to outsourcing reduces economic surplus. However a production tax that induces a switch from outsourcing to integration increases economic surplus provided that demand or integration cost are not too high.
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