DP5761 Is Partial Tax Harmonization Desirable?

Author(s): Paola Conconi , Carlo Perroni , Raymond Riezman

Publication Date: July 2006

Keyword(s): tax competition , commitment , partial coordination

JEL(s): C73 , F21 , H21

Programme Areas: International Trade and Regional Economics , Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP5761.asp.asp

We consider a setting in which capital taxation is characterized by two distortions working in opposite directions. On one hand, governments engage in tax competition and are tempted to lower capital tax rates. On the other hand, they are unable to commit to future policies and, once capital has been installed, have incentives to increase taxes. In this setting, there exists a tax that optimally trades off the two distortions. We compare three possible tax harmonization scenarios: no tax harmonization (all countries set taxes unilaterally), global tax harmonization (all countries coordinate their capital taxes), and partial tax harmonization (only a subset of all countries coordinate capital taxes). We show that, if capital is sufficiently mobile, partial tax harmonization benefits all countries compared to both global and no harmonization. Our analysis provides a rationale for the proposed creation of an Enhanced Cooperation Agreement on capital taxes within the European Union.