Abstract
We analyse the choice of commodity tax base, when countries set their taxes non-cooperatively in a reciprocal dumping model of homogeneous goods trade with horizontal foreign direct investment (FDI). We show that the consumption base (destination principle) weakly welfare-dominates the production base (origin principle) for a large range of plant fixed costs. When integration is complete, the destination principle dominates the origin principle for all levels of plant fixed costs below which FDI occurs under the origin principle. This contrasts with much of the existing literature which has tended to support the origin principle under imperfect competition with a fixed market structure.
Highlights
Increasing economic integration has made the choice of commodity tax base an important policy issue, especially within the European Union (EU)
And with the completion of the single market in 1993, the European Commission proposed moving from a value-added tax (VAT) system based on the destination principle to one based on the origin principle
Our results lend some support to the use of the destination principle when there is the potential for foreign direct investment (FDI)
Summary
Increasing economic integration has made the choice of commodity tax base an important policy issue, especially within the European Union (EU). A number of papers have used models of imperfect competition to look at the choice of commodity tax base when countries set their taxes noncooperatively.2 Keen and Lahiri (1998) employ a duopoly model with integrated markets, a homogeneous good, and no transport costs, and show that taxation under the origin principle leads to the first-best outcome when taxes are set non-cooperatively and the firms and countries are symmetric. We allow for the possibility that firms want to engage in trade-cost jumping horizontal FDI by introducing a preliminary location decision to the game This decision takes the form of whether to build a new plant in the firm’s export market at some fixed cost. We have relegated most of the mathematical derivations and proofs to the appendix
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