Lecture 4- Interjurisdictional Competition: Tax Competition

1.Indirect Taxes (international issues)

1.1. Overview
1.2. Destination and Origin Principles
1.3. The European Single Market
1.4.Cross-Border Shopping
1.5.Economic Analysis of Destination and Origin Principles
1.6 Indirect Tax Competition and Coordination
1.6.1 Possibilities for Coordination
2. Taxation of Income from Capital (international issues)
2.1.Source and Residence Principles for Taxing Capital Income
2.2. Economic Properties of Residence- and Source-Based
Taxes
2.3. Tax Competition and Public Good Provision Under Source
and Residence Principles
3 Empirical Testing
1
1.1. Overview
Two methods for taxing flows of goods and services that cross
borders, the destination and origin principles
Destination principle v origin principle: which is more efficient?
When are they equivalent?
Strategic tax setting: how should individual countries set their
tax rates in the context of cross-border flows of goods?
Are there any gains from coordination of indirect taxes? If so -
what form of coordination? Tax harmonisation vs. minimum
taxes
1.2. Destination and Origin Principles
Destination principle: consumers pay tax on an imported good at
the importing country's tax rate
Origin principle: consumers pay tax on an imported good at the
exporting country's tax rate
1.3. The European Single Market
In the EU, which principle applies depends on whether good is
imported by a firm or a private individual
- If a firm imports the good, the destination principle applies
- But if an individual imports the good, the origin principle applies
since the introduction of the Single European Market in 1 Jan
1993:
EC Directive 92/12/EEC - as regards products acquired by
private individuals for their own use and transported by them, the
2
principle governing the internal market lays down that excise duty
shall be charged in the member state in which they are acquired.
In practice all imports to EU countries from other EU countries are
subject to no restrictions, except (i) that tax must have been paid in
the country of purchase of the good; and (ii) that good are not for
resale.
Condition (ii) is enforced by generous upper limits, plus random
customs checks at borders.
For example, according to the UK Customs and Excise,, "if you
bring back large quantities of alcohol or tobacco, a Customs
Officer is more likely to ask about the purposes for which you hold
the goods. This will most likely be the case if you appear at the
airport with more than: 3200 cigarettes, 400 cigarillos, 200 cigars,
3kg of smoking tobacco, 110 litres of beer, 10 litres of spirits, 90
litres of wine, 20 litres of fortified wine i.e.: port or sherry".
1.4.Cross-Border Shopping

The origin principle of the single European market has created
incentives for tax-induced cross-border shopping (i.e. legal
importing of goods by private individuals from low tax countries to
high-tax countries) and smuggling.
The volume of cross-border shopping is likely to be greater:
- the bigger the tax differential on the commodity
- the nearer are the two countries
Relevant case: UK and France, with big differentials in taxes on
alcohol and tobacco products. As of November 2001, excise taxes
were:
UK France
Beer 34p/pint 5p/pint
Spirits (70cl bottle) 5.48 2.51
3
Wine (75cl bottle) 1.16 0.00
20 cigarettes 2.80 1.22
In 1999 there were an estimated 2.3 million cross-border
shoppers from the UK (travellers whose main purpose was to
shop). The most important destination for cross-border shopping is
France, which was visited by 92.8% of cross-border shoppers in
1999. (Lockwood and Migali(2007))
Estimates of lost UK tax revenues due to cross-border shopping
and smuggling in 1999: 305m on alcohol products, 935m on
tobacco products. (Lockwood and Migali(2007))
Minimum Taxes
At the EU level, there was concern about the single market leading
to a process of tax competition i.e. countries might cut excise taxes
(and possibly VAT) to attract cross-border shoppers
Also, a belief that for the single market to work efficiently,
harmonisation of taxes is required.
1987- Commission proposes harmonisation of VAT rates and
excise duties in narrow bands e.g. VAT band of 14-20%, reduced
rate of 4-9%
Due to pressure from higher-tax countries, including the UK, these
proposals were changed in 1989, with a directive 92/84/EEC in
1992 specifying minimum excise duties and VAT rates
Minimum tax rate
VAT 15%
cigarettes 57% of retail price
petrol 337 Euro/1000 lit (leaded), 287
Euro/1000 lit (unleaded)
Alcohol
products
Variety of rates, including zero
minimum on wine
1.5.Economic Analysis of Destination and Origin Principles
Two countries, home H, and Foreign, F.
4
Firms in each country produce a single good for either domestic
market or for export (e.g. cars)
Assume single currency (realistic for EU) so money exchange rate
=1.
In each country, the market for each good is competitive
Also, consumers can cross-border shop at zero cost
*
, q q
= price paid by consumers for the good in the two countries
i.e.
q
in H and
*
q
in F
*
, p p
= price paid to producers for the good in the two countries
i.e.
p
in H and
*
p
in F
* , t t
= ad valorem tax rates on the good in H and F
Destination Principle
There can only be one consumer price in each country:
In H, consumers pay
) 1 ( * ) 1 ( t p t p q + +
(1)
In F, consumers pay
*) 1 ( * *) 1 ( * t p t p q + +
(2)
(1) and (2) each imply that
* p p
i.e. i.e.
producer prices ARE the same for all producers
(1) and (2) together imply
*) 1 (
) 1 (
*
t
t
q q
+
+

i.e.
consumer prices ARE NOT the same across countries
Origin Principle
5
Again, given that there can only be one consumer price in each
country:
In H, consumers pay
*) 1 ( * ) 1 ( t p t p q + +
(3)
In F, consumers pay
*) 1 ( * ) 1 ( * t p t p q + +
(4)
(3) and (4) each imply that
) t (
*) t (
* p p
+
+

1
1
i. e. producer prices
ARE NOT the same for all producers
(3) and (4) together imply
* q q
i. e. consumer prices ARE the
same across countries
Destination principle implies
equality of producer prices
equal marginal costs, given perfect competition
production efficiency
Origin principle implies
equality of consumer prices
equal marginal willingness to pay for goods
exchange efficiency
Which is best? Diamond and Mirrlees (1971), given perfect
competition - or 100% taxation of economic rent - and no
restriction on tax instruments, then require production efficiency
and hence destination principle
1.6 Indirect Tax Competition and Coordination
6
A simple model based on Nielsen(1998) to study tax competition
and co-ordination.
2 countries large (L) and small (S), on straight line (-1,+1):
- 1 0 b + 1
large country small country
upper case = large country (L) ; lower case = small country (S)
population of 2 uniformly distributed between -1 and +1 (so
population of L is 1+b, population of S is 1-b)
1 good
each individual buys good if his reservation value (V,v) exceeds
the price (P,p)
specific taxes (T,t)
with zero production cost, so price = tax: P=T , p=t
A consumer in either country can either (i) buy the good at her
location in the home country, or (ii) travel to the border and buy
the good in the foreign country (cross-border shopping)
travel costs of c per unit of distance travelled
governments aim to maximise tax revenue
7
Destination-Based Taxes
No cross-border shopping. Thus, the tax base in country L is 1+b
if T V, and 0 otherwise.
So, a revenue-maximising government will set T*=V, giving
revenue R=V(1+b).
Similarly, in S, a revenue-maximising government will set t*=v,
giving revenue r=v(1-b).
Starting at these equilibrium tax rates, is there any tax reform that
will give one or both countries more tax revenue?
No, because (i) each country is maximising tax revenue already;
(ii) there are no tax externalities between countries i.e. R does not
depend on t, and vice versa.
Origin-Based Taxes
An individual in L purchases at border b - i.e. cross-border shops
-if cost of doing so it lower i.e. if cD t T + > , where D = distance of
individual from border
So, any individual in L will cross-border shop if T>t and her
distance from the border, D, is less than
*
D , i.e.:
c
t T
D D

<
*
(1)
So, if T>t , the number of cross-border shoppers from L to S is D*,
because consumers are uniformly distributed along the line.
Likewise, an individual in S purchases at border b if
cd T t + >
,
where d = distance of individual from border. So, any individual in
S will cross-border shop if t>T and her distance from the border, d,
is less than
*
d , i. e:
c
T t
d d

<
*
(2)
So, if T<t , the number of cross-border shoppers from S to L is d*,
because consumers are uniformly distributed along the line.
8
Tax revenue in L =
) t , T ( R
(i) if T t :
) b ( T ) t , T ( R + 1
(ii) if T t < : lose revenue of
c
t T T
TD
) (
*

(iii) if T t > : gain revenue of

c
T t T
Td
) (
*

'

+ +
c
T t
b T t T R 1 ) , (
(3)
Tax revenue in S =
) T , t ( r
(i) if T t :
) b ( t ) T , t ( r 1
(ii) if T t < : gain revenue of
c
t T t
tD
) (
*

(iii) if T t > : lose revenue of

c
T t t
td
) (
*

'

+
c
t T
b t T t r 1 ) , (
(4)
Non-cooperative equilibrium
Find tax reaction functions:
2 2
) 1 (
) ( 0
) , ( t b c
t T
T
t T R
+
+

(5)
and
2 2
) 1 (
) ( 0
) , ( T b c
T t
t
T t r
+

(6)
At Nash Equilibrium, (5) and (6) hold simultaneously, implying that
9

,
_

+
3
1
b
c T
NE and

,
_

3
1
b
c t
NE
t
) (T t

T
Properties of Nash Equilibrium
1.
NE
T
and
NE
t
both proportional to travel cost, c
2.
NE
T increases and
NE
t falls as difference in size of counties (given
by b) increases
3. Since
NE NE
t T > individuals in the Large country up to
3
2
*
b
D away
from the border travel to Small country to shop
4. Total revenue in Large country :
2
3
1 ) , (

,
_

+
b
c t T R
NE NE
exceeds total
revenue in Small country
2
3
1 ) , (

,
_

b
c T t r
NE NE
5. Small country has higher revenue per capita
b
t T R
b
T t r
NE NE NE NE
+
>
1
) , (
1
) , (

10

,
_

+
3
1
b
c

,
_

3
1
b
c
Nash
Equilibrium
) (t T
1.6.1 Possibilities for Coordination
1. Harmonisation taxes harmonised at a weighted average of
NE NE
t T ,
i.e. each country moves to tax rate

, where
NE NE
t ) a ( aT + 1
,
1 0 a
t
) (t T
) (T t

T
tax rates same

no cross border shopping

Hence
[ ] ) b ( t ) a ( aT ) b ( ) , ( R
NE NE
+ + + 1 1 1
[ ] ) b ( t ) a ( aT ) b ( ) , ( r
NE NE
+ 1 1 1
Note that
) , ( r
is highest for a=1 as
NE NE
t T >
11

,
_

+
3
1
b
c

,
_

3
1
b
c
H=
) , (
45
o
But at a=1,
2
3
1 ) , ( ) 1 (
3
1 ) , ( ) , (

,
_

<

,
_

+
b
c T t r b
b
c T T t r
NE NE NE NE

Hence Small country cannot gain from harmonisation
Intuition: the loss from a reduced tax base dominates the gain from
a higher tax
Large country gains if a is "high enough" . Specifically, we need
( ) ( )
b
b
T
b
b b
c
b
c b
NE
+
+

+
+

,
_

+ >

,
_

+ > +
1
3 / 1
1
3 / 1
3
1
3
1 ) 1 (
2

Intuition: the gain from an increased tax base exceeds any loss
due to a reduction in tax rate from T
NE.
2. A minimum tax rate

where
NE NE
T t < <

) (T t

T
It is possible to show that any such minimum tax rate makes both
countries better off
12

,
_

+
3
1
b
c T
NE

,
_

3
1
b
c t
NE
t
T(t)
Mt

,
_

+
3
1
b
c T
NE
First, Large country is unconstrained - so stays on the same
reaction function
Moreover, other things equal, Large country prefers a higher tax in
the Small country
So, intuitive that the Large country will be better off for with any
NE NE
T t < <
(see Question 1)
It can also be shown (see Question 2) that the Small country will
always gain also.
Conclusions
In this very simple model:
- with destination-based taxes, tax coordination is never
desirable
- with origin-based taxes, some tax coordination is always
Pareto-improving (small coordinated tax increase, minimum
tax less than the higher of the two Nash equilibrium taxes)
- But tax harmonisation is never Pareto-improving: the low-tax
country always loses
Questions
1. Show that the large country will be better off moving from non-
cooperative equilibrium to any minimum tax

with
NE NE
T t < <

(Hint: show that the large country revenue is increasing in the tax
set by the small country, for fixed T).
2. Show that the small country will be better off moving from non-
cooperative equilibrium to any minimum tax

with
NE NE
T t < <
.
2 TAXATION OF INCOME FROM CAPITAL (international
issues)
13
2.1 Source and Residence Principles for Taxing Capital Income
Income from capital interest income, dividend income
Can accrue both to individuals and to companies: here, we focus
mostly on individuals
Source principle income is taxed by the government of the
country where the income is generated (source country)
Residence principle income is taxed by government of the
country where the recipient of the income lives (residence
country).
The residence principle is also known as the worldwide principle
of taxation.
What Happens in Practice
Tax treatment of income from capital is governed by double
taxation treaties (bilateral treaties between countries). The UK has
over 100 such treaties. Most countries follow the OECD Model
Tax Convention.
Most countries operate a residence/worldwide system of income
taxation.
But some countries also impose withholding taxes (source taxes
on interest and dividends). The OECD MTC specifies withholding
taxes of at most 15% on dividend income, and 10% on interest
income. The purpose of withholding taxes is prevent tax evasion
by the receivers of capital income.
The two are usually integrated by allowing the investor to claim
the withholding tax paid as a credit against his tax liability in his
country of residence (credit system).
14
However, there is a ceiling to the tax credit, usually set at the tax
due in the country of residence on the income flow.
Example
A UK investor has interest income of 1000 from country A and
1000 from country B. Country A (B) charges a 30% (50%)
withholding tax.
The investors rate of tax in the UK is 40%. So, tax paid on the
two income flows is as follows:
UK Tax Withholding Tax
Investment in A 400 300 = 100 300
Investment in B 0 500
So, effectively, the income from the low-tax country is taxed
according to the residence principle, while the income from the
high-tax country is taxed according to the source principle.
Which of there holds in practice? Key empirical facts:
1. Withholding taxes have been reduced in recent years, with
many low or zero.
2. Institutional investors such as pension funds, life insurance
companies are often tax-exempt in the residence country.
3. For cross-border investment by private individuals, evasion of
residence-based taxes is widespread (Belgian dentists).
15
2.2 Economic Properties of Residence- and Source-Based Taxes
Assume two countries, home (H) and foreign (F), with foreign-
country variables denoted by *.
In a given country, the resident consumer maximises utility of
present and future consumption
) , (
1 0
c c u
subject to the present-
value budget constraint:
w
P
c
c
+
+
1
1
0
where w is the present value of wealth and P is the post-tax return
on the agents savings. So, the FOC for this problem can be
rearranged to yield:
P
c u
c u
+


1
/
/
1
0
(1)
Similarly, the representative consumer in the foreign country sets
*
1
0
1
/ *
/ *
P
c u
c u
+


(2)
Now suppose that in either country, each resident can invest
their savings either at home or abroad, or both. Let the pre-tax
returns on savings in H,F be R,R* respectively.
Residence-Based Taxes
With residence-based taxes, an investor from H or F moves
investments until the pre-tax returns are equalised (ignoring corner
solutions) i.e.
16
R=R* (3)
This is known as capital export neutrality (CEN).
Then, the post-tax returns in the two countries are P=R(1-T), P*=
R(1-T*), where T,T* are the residence-based taxes. So, we have
from (1), (2), (3) that

1
0
1 1
0
/ *
/ *
*) 1 ( 1 ) 1 ( 1
/
/
c u
c u
T R T R
c c
c u


+ +


(4)
i.e. the MRS between present and future consumption cannot be
equalised in the two countries, as long as T T*.
Conclusion: with residence-based taxation, there are generally
international distortions in savings, but no distortions in investment
(CEN) .
Source-Based Taxes
With source-based taxes, the allocation of savings between
countries are adjusted until the post-tax returns are equalised
(ignoring corner solutions) i.e.
(1-T)R=(1-T*)R* (5)
where T,T* are the source-based taxes. Then, the post-tax returns
in the two countries are P=R(1-T)= P*= R(1-T*). i.e. savers in both
countries have the same return on their savings. This is known as
capital import neutrality (CIN).
So, we have from (1) and (4) that
1
0
1 1
0
/ *
/ *
* 1 1
/
/
c u
c u
P P
c c
c u


+ +


(6)
17
Conclusion: with source-based taxation, there are generally
international distortions in investment, but no distortions in savings
(CIN) .
2.3. Tax Competition and Public Good Provision Under Source
and Residence Principles
We extend the previous model to allow for choice of taxes and
public good provision by individual governments. Based on
Zodrow and Mieszkowski (1986).

N identical countries, population within a country normalised to
unity. Each country has a representative firm that produces
output from labour and capital.
Two periods, 0,1 as before. Households in typical country save
S in period 0, which then becomes their second-period
endowment of capital. They can then sell this capital to firms at
price r. They also inelastically supply L units of labour to the
firm located in their country.
In the second period, the representative firm in each country
produces output by a constant returns to scale production
function,
) L , K ( F
where L is the fixed supply from resident
households, K the purchase of capital from households, and
0 >

K
) L , K ( F
F
K
0
2
2
<

K
) L , K ( F
F
KK
Labour is immobile, but capital is freely mobile between
countries.
World price of capital is r, taken as given by households, firms
and governments (N assumed large). [Link to previous model;
r=1+R].
18
In each country, the government supplies a public good G
financed by a tax T on capital K located in the region (source
tax) a tax t on capital owned by residents, S (residence tax),
and a wage tax z. Taxes t,T will be assumed specific taxes for
simplicity i.e. based on physical units of capital, rather than on
the value of capital. One unit of the public good costs 1 unit of
output.
If S is fixed, and t=z=0, we have the original Zodrow and
Mieszkowski (1986) model, the classic model of tax
competition.
Firms
Firms are only active in the second period. They choose K
maximise profit
K ) T r ( ) L , K ( F +
,
T r F
K
K
+

which implies
0
1
<
KK
KK
F dT
dK
dT dK F
.
Note that the source-based tax T distorts the investment decision
i.e. choice of K, but the residence-based tax t does not affect it.
Households
Utility is
) ( ) (
1 0
G v C C u U + +
, where u(.), v(.) are strictly increasing
and concave.
Pre-tax wage income is
K T r L K F wL ) ( ) , ( +
. Post-tax wage
income is
] ) ( ) , ( )[ 1 ( ) 1 ( K T r L K F z wL z +
.
Budget constraints are:
19
wL z S t r C Y S C ) 1 ( ) ( ,
1 0
+ +

Substitute budget constraints into utility function by substituting out
C
0
,C
1
to get
) ( ) 1 ( ) ( ) ( G v wL z S t r S Y u U + + +
Optimal savings choice implies
t r S Y u ) ( '
From the form of the utility function (linear in second-period
consumption, no income effects on S), S depends - positively -
only on after-tax return on savings, r-t, not on second-period wage
income w.
Interesting special case: S independent of r-t, i.e. fixed at S ;
interest-inelastic savings.
Note that the residence-based tax t distorts savings decision i.e.
choice of S, but the source-based tax T does not affect it.
Government
Government budget constraint is
zwL TK tS G + +
The government chooses t,T,z to maximise household utility,
subject to the government budget constraint, and (i) taking r as
given; (ii) taking into account the fact that K depends on T, and S
depends on t; (iii) subject to
z z
.
This is a complex problem; approach this in steps.
First, note that the MRS between G and C
1
is just
) ( ' G v
, and the
MRT between G and C
1
is 1. So the Samuelson Rule says
1 ) ( '
*
G v
. This is shown below.
20
Next, note that the wage tax z does not distort savings,
investment, or labour supply, so it is a non-disortionary tax. So,
there are then two cases. If the wage tax yields enough revenue
to finance G*, then distortionary taxes will not be used i.e. t=T=0.
The condition for this is
* ] ) , ( [ G rK L K F z (1)
where
r L K F
K
) , (
. This is not an interesting case, so we assume
the opposite i.e.
21
G
) ( ' G v MRS
1 MRT
G*
* ] ) , ( [ G rK L K F z < (2)
In this case, the government will set z at its maximum level z in
order to extract as much non-distortionary revenue as possible,
and then will use T,t to finance the remaining part of the cost of G.
Then we can write the objective of government as

]) ) ( ) , ( [ (
] ) ( ) , ( )[ 1 ( ) ( ) ( ) , , (
K T r L K F z TK tS v
K T r L K F z S t r S Y u z T t W
+ + + +
+ + +
Now look at two cases.
A. Special case: competition in source-based taxes only.
Set 0 , 0 t z , and assume S independent of r-t (Zodrow-
Mieskowski assumptions). Then key feature; countries compete
for a fixed stock nS of mobile capital by cutting taxes T.
The objective of government is

) ( ) ( ) , ( ) ( TK v K T r L K F rS S Y u W + + + +
FOC is:
0 ) ( ' )) ( (

,
_

+ + + +

dT
dK
T K G v
dT
dK
T r F K
T
W
K
Use envelope condition
0 ) ( + T r F
K
from optimal choice of K to
get:
0 ) ( '

,
_

+ +
dT
dK
T K G v K
This gives
22
0 , 1
1
1
) ( ' < >
+

+

dT
dK
K
T
dT
dK
T K
K
G v

i.e. the marginal utility from a unit of public good exceeds the
marginal utility from a unit of private consumption
Specifically,
+

1
1
) ( ' MCPF G v
, MCPF=marginal cost of
public funds
utility could be increased by switching from C to G ; there is
underprovision of public goods, as shown below
problem clearly arises because
0 <

T
K
; capital flows out of the
region as the tax rate is increased
23
G
) ( ' G v MRS
1 MRT
G*
+

1
1
MCPF
G**
This outcome can be improved by tax coordination. The model is
symmetric, so we can only look at a small increase (or decrease)
in all taxes.
In the above diagram, suppose, starting at symmetric equilibrium
at G**, all countries raise their taxes so that they can provide the
efficient level of the public good G*.
Then, as all taxes increase by the same amount i.e. there is
coordination, there is no capital inflow or outflow from any country.
This implies that the perceived marginal cost of providing
additional units of G is MRT=1, not
+

1
1
MCPF
. Then, the gain of
moving to G* exceeds the cost.
That is, all countries gain from a coordinated increase in taxation.
24
G
1 MRT
G*
+

1
1
MCPF
G**
Cost of increasing supply from
G** to G* = A
Benefit of increasing supply
from G** to G* = A+B
A
B
To look at tax harmonisation, or the effects of setting a minimum
tax rate, an extension of the basic Zodrow-Mieskowski model to
countries of different size (or other different characteristics) must
be undertaken.
Key result is that a minimum tax rate is better than harmonisation,
as in the case of indirect taxes.
B. General case: competition in both source-based and residence-
based taxes.
Recall that
]) ) ( ) , ( [ (
] ) ( ) , ( )[ 1 ( ) ( ) ( ) , , (
K T r L K F z TK tS v
K T r L K F z S t r S Y u z T t W
+ + + +
+ + +
When calculating FOC for choice of t,T, we use envelope
conditions:

0 ) ( + T r F
K
from optimal choice of K
t r S Y u ) ( '
from optimal choice of S
0 ] ) 1 )[( ( ' ) 1 ( + +

dT
dK
T K z G v K z
T
W
(1)
0 ] )[ ( ' + +

dt
dS
t S G v S
t
W
(2)
Results
1. If all tax instruments are unconstrained, then only the
residence-based tax will be used in equilibrium. That is, if
1 z , T=0, whereas t>0.
25
This is the Diamond-Mirlees theorem in the context of this model.
To see the result, set 1 z in (1) to get
0 ) ( '
dT
dK
T G v
which can only
be true if T=0.
One intuition is as follows. An increase in T has two negative
effects. It lowers the use of capital by firms, and it also lowers
wage income and thus the base of the wage tax. The larger the
feasible wage tax, the more important this second effect is.
2. If savings are completely interest inelastic i.e. S is
independent of r-t, then , then only the residence-based tax
will be used in equilibrium. That is T=0, t>0.
This is an important result, because it shows that at least under
certain conditions, tax competition to attract mobile capital will not
occur.
Also, note that in cases 1 and 2, because countries will choose
only residence-based taxes, there no tax coordination and thus no
role for tax coordination. The choice of tax is second-best efficient.
3. If the wage tax is constrained, then generally, both
residence-based and source-based taxes will be used in
equilibrium. That is, if 1 < z , T>0, t>0.
In this case, what is interesting is the relative size of the two taxes.
Rearrange (1), (2) to get formulae of the form:
dT dK
z
v
v
K
T
/
) 1 (
'
) 1 ' (

(3)
dt dS v
v
S
t
/
1
'
) 1 ' (

(4)
Note that T/K, t/S are the ad valorem forms of the tax. So, T will
be larger, the more constrained the wage tax is, and the smaller
26
the responsiveness of K to T, and t will be larger, the smaller the
responsiveness of S to T.
- if the elasticity of demand for savings is small and the elasticity of
demand for capital is large, then t will be high and T will be low
i.e. taxation will be mostly residence-based
- if the elasticity of demand for savings is large and the elasticity of
demand for capital is small, then t will be low and T will be high
i.e. taxation will be mostly source-based
3 Empirical Testing
Lockwood and Migali (2008)
Estimates excise tax reaction functions which describe the setting
of excise taxes by EU countries both before and after the single
market
Basic specification is
it it t i t t i i it
Z D f + + + +

' ) (
, ,
where :
it

is excise tax at time t in country i

i j
t j ij t i
w
, ,

is weighted average of other taxes (weights
sum to 1)
0 >
ij
w
iff i and j share a common border
t
D
is a dummy for the single market
it it
Z ,
; vector of control variables, and an error term
27
Basic hypothesis: > 0 as the SM creates cross-border shopping
and thus tax competition (as in Nielsen model)
The Data
- Balanced panel from 12 EU countries over 17 years, 1987 and
1989-2004 inclusive. We consider only the countries which were
members of the EU in 1987.
- Data are not available for the year 1988, so there are 204
observations.
- Data on excises are based on the Excise Duty Table issued by
the European Commission, cross-checked against the available
issues of the Inventory of Taxes (only available for 1994, 1999,
2002).
- Taxes on five kinds of products; still wine, sparkling wine, beer,
cigarettes, and ethyl alcohol (spirits)
- All of these products, except for cigarettes, are only subject to
a specific excise tax i.e. levied per unit of physical quantity.
- For cigarettes, we have the specific tax, and the total tax
(specific, ad valorem, and VAT) as a percentage of the retail price.
- Where there are several rates of tax e.g. standard and reduced
rates, we use only the standard rates.
- Controls: country population, GDP per capita, government final
consumption expenditure as a % of GDP, Schmidt Index (left,
centre, right government)
Main Results
STILL WINE SPARKLING WINE
87-92 93-04 87-92 93-04

-i
-0.165
(0.318)
-0.521
(1.458)
0.423***
(0.151)
-0.044
(0.417)
-0. 704
(2.467)
1.215***
(0.323)
D x
-i
0.280**
(0.131)
n.a. n.a. 0.280**
(0.095)
28
Reject H
0
that all
coeffs are equal
in two regressions
Reject H
0
that all
coeffs are equal in
two regressions
* - sig. at 10%, ** - sig at 5%, *** - sig at 1%, SEs in brackets
BEER ETHYL ALCOHOL
87-92 93-04 87-92 93-04

-i
0.130
(0.200)
0.215
(0.456)
0.309*
(0.175)
-0.260
(0.496)
0. 334
(0.320)
0.649**
(0.257)
D x
-i
0.199**
(0.084)
n.a. n.a. 0.261**
(0.115)
Reject H
0
that all
coeffs are equal
in two
regressions
Reject H
0
that all
coeffs are equal in
two regressions
* - sig. at 10%, ** - sig at 5%, *** - sig at 1%, SEs in brackets
CIGARETTES SPECIFIC CIGARETTES TOTAL
87-92 93-04 87-92 93-04

-i
1.070***
(0.251)
0.497***
(0.182)
1.320***
(0.277)
0.761***
(0.128)
1.070***
(0.091)
1.007***
(0.058)
D x
-i
-0.045
(0.156)
n.a. n.a. 0.074**
(0.031)
Reject H
0
that all
coeffs are equal in
two regressions
Reject H
0
that all
coeffs are equal in
two regressions
* - sig. at 10%, ** - sig at 5%, *** - sig at 1%, SEs in brackets
29