We examine the impact of commodity taxation on vertically differentiated pr
oduct markets when entry is allowed. We show that an ad valorem tax may hav
e a dramatic effect on market structure by inducing the entry of a large nu
mber of firms in what was previously a natural monopoly. The producers of h
igh quality products reduce market share after an increase in their unit pr
oduction cost, leaving more room for lower quality products. While within a
given market structure aggregate quality decreases monotonically with the
tax rate, quality jumps upwards at tax rates that cause a change in market
structure. (C) 1999 Elsevier Science B.V. All rights reserved.