International spillover effects of sectoral tax differentiation in unionized economies

Abstract

Sectoral tax differentiation has in recent years appeared on the agenda in European policy discussions concerning unemployment. The member countries of the European Union are allowed to reduce the value added tax rates on goods and services that are particularly labour intensive and price elastic. This paper provides a theoretical analysis of the international repercussions of such policies. We develop a two-country and two-sector model with monopolistic competition in the goods market and wage bargaining in the labour market. Policy externalities operate through the endogenously determined terms of trade. We examine how national and supranational commodity tax policies affect sectoral and total employment and characterize optimal commodity taxes with and without international policy cooperation. Some rough estimates of the welfare gains from policy coordination are also presented, using a calibrated version of the model. Copyright 2002, Oxford University Press.