We analyze Nash and cooperative tax-setting among heterogeneous jurisdictions that form a customs union. Two countries differ in population (hence market size) but share a perfectly integrated product market and a common external tariff.

Non-cooperative equilibrium:

The large country’s domestic tax base is less export-oriented and less elastic than the small country’s; therefore, in the non-cooperative equilibrium it imposes a higher commodity tax and enjoys greater per-capita revenue, while the small country undercuts to attract mobile consumers and firms. This creates a regressive transfer of real income from the small to the large country and generates a fiscal externality that lowers overall union welfare.

Harmonisation:

Moving from Nash to full harmonisation (a uniform ad valorem rate and formula apportionment of the common base) raises joint welfare provided that side transfers are allowed; without side transfers the large country loses and harmonisation is blocked.

Minimum harmonised rate:

We characterise the minimum harmonised rate that secures unanimous consent and show that it is increasing in the relative size of the large country and in the elasticity of cross-border shopping. Because the required rate is below the large country’s Nash rate, harmonisation lowers aggregate revenue; efficiency gains therefore rely on shifting the tax burden from the small to the large country and on eliminating wasteful compliance costs.

Calibrated results for the EAC:

A calibrated version for the EAC suggests that, even with side payments, harmonisation improves union welfare by only 0.2% of GDP; the gain rises to 1.1% when the model is extended to allow for profit-shifting multinationals and a common corporate tax base.