Patterns of Tax Arbitrage and Decentralized Tax Autonomy

The abolition of internal border controls in the European Union (EU) creates new opportunities of tax arbitrage for rational economic agents. Cross-border shopping and trade deflection become important sources of tax avoidance when tax rates differ across countries. The paper identifies arbitrage patterns for the value-added tax (VAT) proposals of the European Commission as well as a restricted origin regime within the EU. Since any of these regimes causes non-equivalence to the benchmark case of a global destination-bases VAT, calls for a further harmonization of European VAT rates are likely to remain. In contrast, a mixed VAT system which follows the origin principle within the EU but a common destination principle between the EU and the rest of the world, is shown to be equivalent to a pure destination regime. This mixed regime allows for maintaining nationally dispersed VAT rates, and it also reduces the required price adjustment vis-…-vis the rest of the world by an optimal selection of the common external tax.