Article

International Tax and Public Finance

, Volume 19, Issue 4, pp 574-597

First online:

Games within borders: are geographically differentiated taxes optimal?

  • David R. AgrawalAffiliated withDepartment of Economics, University of Michigan Email author 

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Abstract

The discontinuous tax treatment of sales at borders creates incentives for individuals to cross-border shop. This paper addresses whether it is optimal for a state composed of multiple regions to levy differentiated commodity tax rates across the regions. In a model where states maximize social welfare, a state’s optimal commodity tax system is almost always geographically differentiated. The optimal pattern of geographic differentiation critically depends on fundamental parameters as well as whether the state has a preference for high or low taxes. Under the assumption that utility is linear in consumption and that the elasticity of cross-border shopping is less than unity in absolute value, high-tax states will find it optimal to set a tax rate that is lower in the border region than in the periphery region and low-tax states will find it optimal to set a tax rate that is higher in the border region than in the periphery region. Optimizing high-tax states will set a higher tax rate in the border region if the social welfare measure is sufficiently redistributive. With welfare maximization, it is possible for taxes to be higher in the region near the state border—an outcome that cannot arise when the government cares only about total tax revenue.

Keywords

Commodity taxation Cross-border shopping Tax competition Preferential tax rates

JEL Classification

H21 H25 H73 H77 R12