Reforming an asymmetric union: On the virtues of dual tier capital taxation

• We analyse a dual tier capital tax structure for asymmetric unions.
• Tax competition between countries remains, but only in the second tier.
• Small and large countries both gain from the dual tax structure.
• The advantages are maintained when costly side payments are allowed for.

The tax competition for mobile capital, in particular the reluctance of small countries to agree on measures of tax coordination, has ongoing political and economic fallouts within Europe. We analyse the effects of introducing a two tier structure of capital taxation, where the asymmetric member states of a union choose a common, federal tax rate in the first stage, and then non-cooperatively set local tax rates in the second stage. We show that this mechanism effectively reduces competition for mobile capital between the members of the union. Moreover, it distributes the gains across the heterogeneous states in a way that yields a strict Pareto improvement over a one tier system of purely local tax choices. We also discuss the effects of diverging capital endowments within the union and capital flows to third countries.