Coordination of commodity taxes between member countries of the European Union has been a policy issue since the mid-1980s. In Discussion paper No 1304 Research Fellow Ben Lockwood investigates whether it is possible to find Pareto-improving commodity tax reforms that harmonize taxes between two countries when governments supply public goods and thus have revenue requirements.

This paper uses a two-country model with two goods, a single factor of production (labour) in elastic supply, and constant returns to scale in order to focus on the basic issues. It also assumes that initial taxes for either country are welfare-maximizing, taking the taxes of the other country as given i.e. Nash equilibrium taxes. It does not restrict harmonizing tax reforms to leave producer prices unchanged. An example suggests that harmonization is unlikely to be Pareto-improving if the revenue requirement is high, and the demand for imports relatively price elastic, in both countries. An alternative definition of harmonization, difference harmonization, which may yield Pareto-improvements under more general conditions, is proposed.