Two-dimensional fiscal competition

There is a growing literature on commodity tax competition among countries in the European Union (EU). The motivation for this may be due to the fact that different value-added tax (VAT) without physical border control induces cross-border shoppers who pay the VAT of other countries rather than their own. Since such cross-border shopping among the EU member countries directly affects each government revenues, tax competition is an essential economic problem for the EU to solve. Also, there is an evident relationship between the geographical elements of countries and the present VAT rates in the EU, as pointed out in Kanbur and Keen(1993), and Ohsawa(1999,2001). Thus, it is worthy to close examine the tax revenue and cross-border activity based on commodity tax competition within a geographical setting. Analytical studies on commodity tax competition in a linear market has received attention in the literature for the last few years. The exsisting studies clarified the impact of the spatial characteristics such as country size and position on tax rates, tax revenues, and number of cross-border shoppers. However, one of their common limitation is the assumption of a linear market, even though countries in real world are laid out in a two-dimensional market. To the best of our knowledge, analytical approaches on tax competition in two-dimensional market have received remarkably little attention from researchers. Thus, this paper is an attempt to overcome the said limitation of the previous studies. It aims to set up a Nash game between two neighboring countries in two-dimensional market, and to analyze how the two-dimensional market characterizes Nash equilibrium. When one turns from a one-dimensional market to a two-dimensional market, the essential difference between the two markets is country shape such as the length and curvature of the national border. In order to pinpoint the effects of such spatial characteristics, we employ the simplest model. This paper proves three conclusions in a geographical sense. First, small country sets lower tax than big country, and per capita revenue of small country is larger than big country. Second, these two countries are subject to fiercer competitive pressure in a more curved and/or longer national border. Finally, the impact of border curvature on tax and revenue differences are always incompatible with that on tax and revenue ratios.