Resource Allocation and Tariff Strategies: Rethinking VAT in the Context of Monopolistic Competition

We study optimal commodity taxation in an open economy with monopolistic competition and asymmetric fiscal capacity. In a two-country model, a supranational authority uses destination-based consumption taxes to finance public spending, correct market distortions, and redistribute across countries. We show that in the first-best, domestically produced goods are always subsidized, while cross-border tax differentials emerge based on relative labor valuations. In the second-best, when lump-sum transfers are unavailable, the optimal tax system resembles a pattern of asymmetric tariffs: goods from countries with lower marginal costs of public funds are subsidized, while more competitive trade directions are taxed. These results challenge the conventional neutrality of VAT under trade liberalization and suggest that differentiated tax treatment by origin can improve welfare. Our findings call for a reassessment of uniform VAT regimes, especially in economically asymmetric unions.