The financing of a public good from distortionary commodity taxes in member countries of a free trade area with uncoordinated tax policies is of interest for two reasons. First, it is well known that a switch at given rates from origin- to destination-based taxes has no real effects, provided that tax rates are the same on all goods within each country, all prices (including wages) are flexible, and factors of production are supplied inelastically; but it is of interest to examine the effects of relaxing these (rather strong) assumptions. Second, the completion of the single market may induce EC member states to cut commodity taxes to encourage cross-border shopping. With border controls, both destination and origin regimes are feasible, but their abolition implies a switch for goods whose value is high relative to transport costs for which the destination regime was previously in operation.

In Discussion Paper No. 733, Research Fellow Ben Lockwood develops a market-clearing model for a `small' country (taking its terms of trade as given) to show that such a switch leads to the equalization of consumer prices (so that a tax on any particular commodity is effectively a tax on the factors employed in its manufacture), rather than producer prices (when commodity taxation controls consumer prices as in a closed economy). This switch is therefore equivalent to imposing uniformity on commodity taxes, which almost always makes countries worse off. He then shows that such a switch can also give `large' countries incentives to manipulate their terms of trade, but it is not clear a priori whether this will tend to raise or lower taxes, and it introduces a further negative externality, since the tax on a traded good is levied by the exporting country, which is unconcerned about consumers elsewhere. Since taxes may rise or fall overall, the switch may raise the welfare of a typical consumer, in contrast to the small-country case. Lockwood concludes that allowing for differentiated taxes renders the standard neutrality result on the choice of regime invalid; so a regime switch may be expected to induce member countries to change, but not necessarily to reduce, their tax rates.

Commodity Tax Competition Under Destination and Origin Principles
Ben Lockwood

Discussion Paper No. 733, November 1992 (AM/IT)