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. 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. Moving from Nash to full harmonization (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 harmonization is blocked. We characterize the minimum harmonized 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, harmonization 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. A calibrated version for the EAC
suggests that, even with side payments, harmonization 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.