Reforming an Asymmetric Union: On the Virtues of Dual Tier Capital Taxation

The tax competition for mobile capital, in particular the
reluctance of small countries to agree on measures of tax
coordination, has ongoing political and economic fallouts within
Europe. We analyse the effects of introducing a two tier structure
of capital taxation, where the asymmetric member states of a union
choose a common, federal tax rate in the first stage, and then
non-cooperatively set local tax rates in the second stage. We show
that this mechanism effectively reduces competition for mobile
capital between the members of the union. Moreover, it distributes
the gains across the heterogeneous states in a way that yields a
strict Pareto improvement over a one tier system of purely local
tax choices. Finally, we present simulation results, and show that
a dual structure of capital taxation has advantages even when side
payments are feasible.