In general, efficiency losses from regional tax diversity do not appear to be great enough to make a strong case for regional tax uniformity.
In a closed economy, a commodity tax drives a wedge between the producer price and the consumer price. In open economies, intercountry differences in commodity taxation can induce two additional distortions:
Such distortions can be avoided by harmonizing tax rates, ensuring efficiency regardless of the tax principle adopted. At least, that is the theoretical rationale for international tax harmonization.
Regionally such harmonization can be justified, because equalities between marginal rates of substitution and transformation exist between economically integrated countries. Removing barriers to trade and factor movement exposes the allocation of resources more directly to tax rate differentials.
But gains in production and consumption efficiency derived from regional harmonization are not great. Moreover, by reducing international distortions, harmonization could increase internal distortions and reduce welfare, if the new tax structure is inefficient and does not meet the country's preferences.
Tax rate uniformity does not appear to be the right way to maximize welfare if integrating countries are different. Some flexibility should be maintained. And apart from the misallocation of resources, tax rate diversity can induce strategic behavior.
A country's choice of tax rate can be influenced by the choices of others. Countries can race to cut rates to attract foreign consumers or producers—or if they have market power, they can increase taxes on imported goods and decrease them on exports. So, externalities arise: the "usurpation of the tax base" (in the first example) or the "export of the tax burden" (in the second).
Competition between countries would then lead to Nash equilibria in the tax-rate-setting game, resulting in a welfare level inferior to that attainable by cooperation. In fact, there is some evidence that revenue effects might be large for small countries, where the tax structure is often used as a protective device.
If both harmonization and competition can produce welfare losses, one solution could be coordination measures aimed at reducing exploitation of other member countries through taxation.
This paper—a product of the Development Research Group—is part of background work for the group's program on regionalism and development. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Jennifer Ngaine, room N5-060, telephone 202-473-7947, fax 202-522-1159, Internet address trade@worldbank.org. (39 pages)
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