Customs Unions and Domestic Taxes

Abstract

It is well known that nondiscriminatory domestic taxes and subsidies are perfect substitutes for nondiscriminatory trade policies and would render useless international agreements restricting trade policy alone. The author shows that these instruments generally are imperfect substitutes for trade policy in a customs union. However, in one popular specification of trading patterns, access to such tax powers nevertheless renders a customs union useless. Furthermore, numerical simulations demonstrate that a union may be ineffective in many other cases, severely curtailing the potential unions that are attractive to both members. The author illustrates the restrictive conditions under which a union will then form.

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