Journal of Public Economics 93 (2009) 939–949

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Journal of Public Economics

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International commodity taxation in the presence of unemployment

Simone Moriconi a,b,⁎, Yasuhiro Sato c

a SEMeQ, Università del Piemonte Orientale, Via Perrone 18, 28100, Novara, Italyb CEP, London School of Economics, Houghton Street, London, WC2A 2AE, UKc Graduate School of Economics, Osaka University, 1-7, Machikaneyama, Toyonaka 560-0043, Japan

⁎ Corresponding author. SEMeQ, Università del PiemoE-mail addresses: simone.moriconi@eco.unipmn.it (

ysato@econ.osaka-u.ac.jp (Y. Sato).1 The origin principle taxes local production and impo

principle taxes local consumption and exports are exem

0047-2727/$ – see front matter © 2009 Elsevier B.V. Adoi:10.1016/j.jpubeco.2009.03.002

a b s t r a c t

a r t i c l e i n f o

Article history:Received 4 October 2006Received in revised form 15 December 2008Accepted 20 March 2009Available online 26 March 2009

JEL classification:F16H87J23

Keywords:Commodity taxationDestination principleOrigin principleUnemploymentEmployment externality

In this paper, we evaluate the impact of commodity tax competition on welfare and employment under thedestination and origin principles, when the labor market is imperfectly competitive owing to a binding fixedwage. Our main finding is that commodity taxation causes an employment externality whose signs may beopposite under the two principles. While tax competition leads to inefficient tax rates under both principles,we also prove that the origin principle guarantees lower unemployment and higher welfare when the fixedwage is high. Finally, we show that the employment externality still exists in a standard union model of wagedetermination.

© 2009 Elsevier B.V. All rights reserved.

1. Introduction

Following the 1993 reforms, European Value Added Tax (VAT) hasbeen a hybrid system that applies the origin principle to consumers'transactions and the destination principle to firms' transactions (Keenand Smith,1996).1 The current situationwasmeant to be transitionarywhile European and national authorities debated a definitive design ofindirect taxation in the European Union (EU). The Committee onEconomic and Monetary Affairs (European Parliament (2008)) hasrenewed concerns about the reliability of the destination principle inthe EU, and supports a switch to the origin principle to help to preventtax evasion (Nam et al. (2001)). The European Commission (EC) alsosuggested the introduction of reduced VAT rates to encourage thecreation of jobs in labor intensive sectors (European Commission(2003). This focus on an “employment friendly” VAT is based on thefact that product market and labor market institutions are comple-mentary in determining aggregate unemployment (Blanchard andGiavazzi (2003), Nicoletti and Scarpetta (2005), Ebell and Haefke(2003)). From this perspective, given the persistent dismal employ-

nte Orientale, Italy.S. Moriconi),

rts are exempt; the destinationpt.

ll rights reserved.

ment performance in EU countries (Nickell and Layard (1999), DGEFA,European Commission (2005)), it is useful to explore the effects ofconsumption taxes on employment as these duties account forroughly one third of the tax wedge (see Daveri and Tabellini (2000),Fiorito and Padrini (2001), and Bassanini and Duval (forthcoming)).

The literature on commodity tax competition has neglected toevaluate the effects of the effects of consumption taxation on unem-ployment, and to compare the welfare of the destination and originprinciples in the presence of labor market distortions.2 Mostcontributions in this field assume a perfectly competitive labormarketand propose alternative hypotheses about the type of competition inthe product market. Kanbur and Keen (1993) and Mintz and Tulkens(1986) provide normative support for the destination principle inproduct markets with perfect competition. Keen and Lahiri (1998), inan international duopoly model, find that tax competition under theorigin principle delivers the first-best outcome. However, Lockwood(2001) and Haufler and Pflüger (2004) show that this result does nothold with monopolistic competition and mobile firms. Behrens et al.

2 Partial exceptions are Lockwood et al. (1994) who study the equivalence of thedestination and origin principles of commodity taxation when wages are fixed andchecked for the unemployment effects of a switch from the former to the latter whentax rates are fixed, and Michaelis and Pflüger (2000) who consider the employmenteffect of commodity tax reform under the destination and origin principles.

940 S. Moriconi, Y. Sato / Journal of Public Economics 93 (2009) 939–949

(2007) show that under the destination principle, a tax increasealways generates an outflow of firms, but this is not always the caseunder the origin principle in a model withmonopolistic competition àla Ottaviano, Tabuchi, and Thisse (2002) (see Haufler and Pflüger,(2007) for a review).

The present paper contrasts with previous studies in analyzingcommodity tax competition in a perfectly competitive product marketbut with a labor market that is imperfectly competitive. We consideran economy comprised of two symmetric countries, in which privatesector firms produce two goods differentiated by their consumption,and the public sector provides a homogenous public good. Theindividual utility is increasing in the consumption of private andpublic goods. The production of private goods is country specificunder constant returns to scale (CRS) and labor is the only input.Consumption in each country takes place via international trade withzero transport costs and is subject to taxation, which finances theprovision of the public good. The government of each country choosesa commodity tax rate that maximizes the expected utility of workers(i.e., the sum of the utilities of employed and unemployed individualsweighted by the employment probability). Unemployment in theeconomy arises because workers are internationally immobile and aminimum wage in the private sector increases the unit cost of laborabove the level that would ensure full employment.3

The methodology adopted in the most recent studies of commod-ity tax competition focusses on non-cooperative tax policies4 and onthe concept of the indirect utility function. We adopt the sameapproach since it allows us to isolate individual externalities triggeredby a tax change in one country on thewelfare of the other, as drivers ofgovernment tax setting.

In the first part of the paper, we adopt a homothetic utility functionand find that wage rigidity associates commodity taxation with anemployment externality which may take opposite signs under the twoprinciples. Under the destination principle, a rise in the domestic taxrate has a negative impact on foreign employment and welfare whenproducts are either substitutes or complements. When goods arecomplements, this also applies under the origin principle. In the caseof product substitutes, an increase in domestic taxes has a positiveimpact on foreign employment andwelfare under the origin principle.

A negative employment externality leads to inefficiently highequilibrium tax rates under the destination principle, and under theorigin principlewhen the traded goods are complements and tax ratesare positive. Otherwise, the effect of the origin principle is ambiguousas the externalities act in opposite directions. In the second part of thepaper, we check the robustness of our results under a quadratic utilityfunction. This allows us to confirm that a tax policy based on the originprinciple delivers inefficiently high tax rates when goods arecomplements. If goods are substitutes and labor market distortionsare high enough, a tax policy based on the origin principle deliversinefficiently low tax rates. We also show that the origin principleguarantees lower unemployment and higher welfare when fixedwages are high. Finally, we show that in a standard union model ofwage determination the employment externality still exists.

Our results contrast sharply to those in previous studies thatassume full employment and focus on imperfect competition in the

3 A minimum wage facilitates the introduction of wage rigidity into the theoreticalmodel (see Ogawa et al., 2006). Moreover, it is an important determinant ofunemployment in EU countries. For the analysis of the case of endogenous wagedetermination see Section 4 (for studies of labor market institutions and unemploy-ment in the EU see Brown (1999); Bazen and Martin (1991); Checchi and Lucifora(2002); Bertola et al. (2002); DGEFA, European Commission (2005)).

4 Commodity tax policies are mainly set at the national level in the EU. Despite someweak attempts at coordination, the minimum VAT rate of 15% is binding only forLuxembourg, Malta, and Cyprus because of the high reliance of some EU countries onindirect taxation.

productmarket. Keen and Lahiri (1998) and Lockwood (2001) provideexamples where imperfect competition in the product market rendersthe origin principle superior to the destination principle in terms ofwelfare. When market power creates a markup over competitiveprices, an equilibrium under the origin principle is characterized bylower tax rates (i.e., lower consumer prices) and higher consumptionand welfare than under the destination principle (see Haufler andPflüger (2004) for an exception). A similar mechanism comes intoplay, but without firm market power, if imperfect competition isallowed in the labor market. When a binding rigid wage increases unitcosts (i.e., producer prices) over the competitive level, tax policyunder the origin principle may guarantee lower tax rates andconsumer prices than the destination principle. The origin principlethen is consistent with higher consumption, production, employmentand welfare than the destination principle.5

The paper is structured as follows. Section 2 introduces the basicstructure of the model and shows the existence in commodity taxes ofan employment externality and Section 3 characterizes the welfareproperties of non-cooperative taxation under both principles. InSection 4, we specify the functional forms to compare the twoprinciples in terms of employment and welfare, and to discuss thecase of endogenous wage determination. Section 5 provides someconcluding remarks.

2. The model

We describe unemployment resulting from the provision of aminimumwage by using a fixed-wage model à la Bhagwati (1968), inwhich exogenously fixed wages lead to unemployment.

2.1. Consumption

Consider two symmetric countries, Home and Foreign, where thelatter is denoted by an asterisk (⁎). Each country is endowed with acontinuum of immobile workers/consumers of unit measure 1. Theworkers obtain utility from the consumption of three goods: X, Y, andZ. The production of X and Y is country specific. X is produced in Homeand Y in Foreign. X and Y are freely traded and their consumption istaxed. Z is the numeraire, which is assumed to be untaxed.6 Workershave an identical utility function of the following quasi linear form:

U X; Y; Z;Gð Þ = u X;Yð Þ + Z + v Gð Þ; ð1Þ

where u(X,Y) is the utility of the consumption of private goods, and v(G)is the utility of the consumption of the local public good. u(X,Y) and v(G)are increasing and concave (i.e., uXN0, uYN0, uXXb0, uYYb0, uXXuYY−uXY2 N0, and v'N0, vqb0), where the subscript represents the partial

derivative (e.g., uX=∂u/∂X).Owing to a binding fixed wage in the economy, workers can be

either employed (e) or unemployed (u). A type h worker (h=e,u) inboth countries has one unit of labor and some units of the numeraire Z

5 If we assume wage flexibility (i.e., full employment), there is no net externalityfrom commodity taxation under the destination principle, and we return to the casesdescribed by Kanbur and Keen (1993) and Mintz and Tulkens (1986). Note that since,in our model, the number of traded goods is not smaller than the number of countries,the Pareto efficiency of the destination principle is obtained as a direct extension of the“Production Efficiency Theorem” (Diamond and Mirlees (1971)) in an open economywith international taxation (Keen and Wildasin (2004)).

6 The hypothesis of an untaxed numeraire is common in the commodity taxcompetition literature and captures the idea that all tax systems exempt some share ofthe national product from taxation. The taxation of all goods at the same rate mayimply equivalence of the destination and origin principles under rather generalconditions (Lockwood et al. (1994)). Our results are robust to the introduction of thenumeraire consumption taxation as long as the numeraire is not produced using labor,or the numeraire taxation is subject to external restrictions.

8 Our results do not change if we introduce capital into production (see Moriconi

941S. Moriconi, Y. Sato / Journal of Public Economics 93 (2009) 939–949

(which describes the individual endowment of non-labor assets). Weassume that Z is sufficiently large to guarantee positive demand forthe numeraire. All workers inelastically supply one unit of labor.Employed workers obtain an exogenously fixed wage rate w;unemployed individuals receive the reservation wage ws, whichincludes the returns from non-firm activities, and the value of leisureand unemployment benefits. The total income of each worker is

Ie = w + Z; Iu = ws + Z; ð2Þ

where we assume w N ws N 0.7 We abstract from the employmenteffect of international wage differentials and assume that the fixedand the reservation wages are the same in both countries. The budgetconstraint of type h worker in Home is given by

qXX + qYY + Z = Ih; ð3Þ

where qX and qY are the consumer prices of X and Y, respectively. Anad valorem tax rate (t) is levied on consumption according to eitherthe destination (d) or the origin principle (o). The two principles areequivalent for the decision over local consumption. Let pX and pY⁎ bethe producer prices. We have the following local consumption prices:

qX = pX 1 + tkð Þ; q⁎Y = p⁎Y 1 + t⁎k� �

;

where k=d,o. The origin and destination principles have a differentimpact on the consumption of imported goods:

q⁎X = pX 1 + t⁎d� �

; qY = p⁎Y 1 + tdð Þ; under the destination principle

ð4Þ

q⁎X = pX 1 + toð Þ; qY = p⁎Y 1 + t⁎o� �

; under the origin principle:

Under the destination principle, the Home tax rate tk affects Homedemand for the imported good Y; under the origin principle, it affectsdemand of the good X* that is exported in Foreign. Since the twocountries are symmetric in all respects, we focus on Home; the resultsfor Foreign can be obtained analogously.

Workers maximize their utility Eq. (1) under the budget constraint(3). First-order conditions yield

uX = qX ; uY = qY ; Zh = Ih − qXX − qYY : ð5Þ

Eq. (5) determines the demand functions X(qX,qY) and Y(qX,qY).Simple comparative statics show that

AXAqX

=uYY

jX j b 0;AXAqY

=AYAqX

= − uXY

jX j ;AYAqY

=uXX

jX j b 0; ð6Þ

where |Ω| is defined as |Ω|=uXXuYY−uXY2 N0. From Eqs. (4) and (6),

we observe that domestic demand under the destination principle (i.e.Xd[pX(1+ td), py*(1+ td)]) is affected only by the domestic tax rate,whereas domestic demand under the origin principle (i.e. Xo[pX(1+to), pY*(1+ to*)]), is influenced by both domestic and foreign tax rates.From Eq. (6), the effect of changes in the tax rate on demand is givenby

AXd

Atd= pX

AXd

AqX+ p⁎Y

AXd

AqY;

AYdAtd

= pXAYdAqX

+ p⁎YAYdAqY

;AXd

At⁎d=

AYdAt⁎d

= 0; ð7Þ

7 Since our utility function is quasi linear, the results do not change if we considerthe tax revenue partly accruing for unemployed individuals as unemployment benefitsin Eq. (2).

under the destination principle, and

AXo

Ato= pX

AXo

AqXb 0; ð8Þ

AYo

Ato= pX

AYoAqX

N 0 if two goods are substitutes b 0 if complementsð Þ;

AXo

At⁎o= p⁎Y

AXo

AqYN 0 if two goods are substitutes b 0 if complementsð Þ;

AYoAt⁎o

= p⁎YAYoAqY

b 0;

under the origin principle. Similar arguments hold for Foreign.

2.2. Production and market equilibrium

We assume that production is country specific. X is produced onlyin Home, whereas Y is produced only in Foreign. Let (x,y) be theproduction of each good in Home and Foreign. Production requireslabor inputs only, and one unit of output is produced by using one unitof labor (i.e., we have the CRS production functions x=L and y=L⁎).8

Under perfect competition, this fixes the producer prices for X and Yattheir unit labor costs

pX = p⁎Y = w: ð9Þ

The product market clearing conditions are given by

x = X + X⁎; y = Y + Y⁎: ð10Þ

The production functions and Eq. (10) determine labor demand ineach country:

L = X + X⁎; L⁎ = Y + Y⁎: ð11Þ

We now analyze the case where the fixed wage is binding, that is,the market clearing wage falls below the fixed wage, resulting inunemployment (0bLkb1, k=d,o). At given tax rates, market equili-brium is summarized by a pair (L,L⁎), determined by Eq. (11). Sincepopulation size for each country is normalized to 1, X and Y (X⁎ andY⁎) represent aggregate demand in Home (Foreign).

Comparative statics for Eq. (11) with respect to tax rates show theeffect of taxchanges on employment under each principle. FromEqs. (7)and (8) we obtain the following (see Appendix A for derivations):

ALdAtd

=AXd

Atdb 0;

ALdAt⁎d

=AX⁎dAt⁎d

b 0; ð12Þ

ALoAto

=AXo

Ato+

AX⁎oAto

b 0;

ALoAt⁎o

=AXo

At⁎o+

AX⁎oAt⁎o

N 0 if two goods are substitutes b 0 if complementsð Þ:

ð13Þ

Eqs. (12) and (13) show that commodity taxation affects domesticemployment. An increase in the commodity tax rate increasesdomestic consumer prices, reducing demand for domestic products.This, in turn, reduces demand for domestic labor and employment.

and Sato (2006)). Since we focus on the consumption behaviour of individuals, we canabstract from the analysis of the determinants of individual labor supply by assumingthat workers inelastically supply one unit of labor. Under this assumption, a positivedemand for non-labor assets (i.e. ZN0) does not affect labor supply or X and Y.

942 S. Moriconi, Y. Sato / Journal of Public Economics 93 (2009) 939–949

Eqs. (12) and (13) also show that foreign commodity taxation hasan impact on domestic employment. Under the destination principle,an increase in the tax rate of Foreign td⁎ lowers its demand for good X,leading to a decrease in employment in Home (∂Ld/∂td⁎b0). Under theorigin principle, an increase in to⁎ shifts demand in Home from Y to X,and increases both production of X and employment in Home if X andY are (gross) substitutes (∂Lo/∂to⁎N0). If X and Y are complements, anincrease in to⁎ reduces domestic demand and production of X, with anegative impact on domestic employment (∂Lo/∂to⁎b0). If consump-tion of X and Y are independent, then under the origin principle, anincrease in to⁎ would have no effect on domestic production andemployment (i.e., ∂Lo/∂to⁎=0).

We consider the impact of foreign commodity taxation onthedomestic employment to bean employment externalityof commoditytaxation; we can summarize the above arguments in the followingproposition (formal derivation and proof are presented in Appendix A).

Proposition 1. Under the destination principle, commodity taxation hasa negative employment externality. Under the origin principle, commod-ity taxation has a positive employment externality if and only if the twogoods are substitutes.

Since previous studies assume a labor market with perfectcompetition, they ignore the existence of an employment externalitycaused by consumption taxation. Proposition 1 states that in thepresence of labor market imperfections, commodity taxation ampli-fies distortions and exports unemployment under the destinationprinciple. However, under the origin principle, commodity taxationmay play a corrective role by exporting employment.

Note that the nature of the externality differs between the twoprinciples. Under the destination principle, the externality is simply a“by-product” of the effect of foreign taxation on foreign consumptiondecisions. Under the origin principle, however, part of the externalityresults from the fact that foreign taxation affects domestic consumerprices (e.g., triggers a consumer price externality. See Lockwood(2001)). This is in line with the observation that is common in theliterature, that under the origin principle, there is a strategicinteraction between the Home and Foreign governments (as eachcan influence the consumption decisions of the other), while underthe destination principle this is not the case.

2.3. Welfare analysis of commodity taxation

The governments of each country finance the provision of thepublic good through a commodity tax. The tax base in Home, under thedestinationprinciple, is pxXd+py⁎Yd and under the origin principle, it ispX(Xo+Xo

⁎). Then, the government budget constraint is given by

Gd = pXXd + p⁎YYd; ð14Þ

Go = pX Xo + X⁎o� �

:

When taxes are set non-cooperatively, each government maximizesnational welfare Wk with respect to the commodity tax rate tk andthe level of the provision of the public good Gk, subject to budget con-straints (14).Wk is defined as the weighted sum of (indirect) utilities:9

Wk = LkU Xk;Yk; Ze;k;Gk

� �+ 1− Lkð ÞU Xk; Yk; Zu;k;Gk

� �= u Xk;Ykð Þ + w − wsð ÞLk + ws + Z − qXXk + qYYkð Þ + v Gkð Þ:

ð15Þ

9 Wk can also be interpreted as the expected utility before the employment status ofeach worker is determined. Moreover, if we rewrite Eq. (15) as Wk=U(Xk,Yk,Zu,k)+wLk, we can interpret it as the objective of a “corporatist” government (Buti et al.(2001)).

The first and last terms respectively of the second line of Eq. (15)are the utilities from private and public consumption. The secondand third terms denote labor income. Every individual obtains at leastws. In addition, employed individuals receive a markup over theirreservation wage described by the wage premium (w − ws). Theremaining terms denote the net savings after private consumptionexpenditure. Each government chooses the level of its policyinstruments by taking the other government's behavior as given,and anticipating the resulting market equilibrium.

3. Non-cooperative taxation

In this section, we describe non-cooperative tax policy. Weexamine how taxation by one government that maximizes nationalwelfare affects welfare in another country.

From Eqs. (4), (9), (14), and (15), we obtain welfare under thedestination principle:

Wd = u Xd;Ydð Þ + w − wsð ÞLd + ws + Z − w 1 + tdð Þ Xd + Ydð Þ

+ v wtd Xd + Ydð Þð Þ;

Note that only Ld depends on td⁎ in Wd. Thus, we have

AWd

At⁎d= w − wsð ÞALd

At⁎db 0: ð16Þ

Under the destination principle, non-cooperative taxation has a

negative wage income externality, which is a direct consequence of thenegative employment externality described in Proposition 1. Both theexistence and size of the wage income externality depend on the wagepremium. Non-cooperative taxation does not trigger an externality iflabor markets are perfectly competitive (and there is full employment),that is, ∂Ld/∂td⁎=0.

We use uX = qX = w 1 + tdð Þ and uY = qY = w 1 + tdð Þ to obtainthe first-order condition for the maximization of national welfare (∂Wd/∂td=0):

AWd

Atd= vVwtd

AXd

Atd+

AYdAtd

� �+ vV− 1ð Þw Xd + Ydð Þ + w − wsð ÞALd

Atd= 0:

ð17Þ

Again, considering Home, the first two terms represent the usualeffects of taxation on domestic welfare via changes in the demand forconsumption and the tax base, and the last term is the effect oftaxation on domestic employment. For Foreign, the situation is similar(∂Wd

⁎/∂td⁎=0). These two conditions determine non-cooperative taxpolicy under the destination principle.10

We now move to analysis of the origin principle. Eq. (15) becomes

Wo = u Xo;Yoð Þ + w − wsð ÞLo + ws + Z

− w 1 + toð ÞXo + 1 + t⁎o� �

Yoh i

+ v wto Xo + X⁎o� �� �

:

Changes in the foreign tax rate, under the origin principle, affectdemand in Home and create a wider range of externalities than under

10 In this paper, we use the local Nash equilibrium as an equilibrium concept,implying that our solution is derived based on first-order conditions only; we assumethat second order conditions for maximization hold. Explicit representation of second-order conditions would include assumptions about the third derivatives of the utilityfunction.

12 When goods are substitutes, wage income and public consumption externalitiesare positive and offset the negative private consumption externality. When goods arecomplements and governments pay a consumption subsidy (i.e. they set negative tax

943S. Moriconi, Y. Sato / Journal of Public Economics 93 (2009) 939–949

the destination principle. From Eqs. (8) and (13), the derivative of Wo

with respect to the foreign tax rate becomes

AWo

At⁎o= vVwto

AXo

At⁎o+

AX⁎oAt⁎o

!|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}

½public�

−wYo|fflfflffl{zfflfflffl}½private�

|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}½effect on consumption�

+ w−wsð ÞALoAt⁎o|fflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflffl}

effect on wage income½ �

: ð18Þ

The first two terms in Eq. (18) capture the public and privateconsumption externalities from commodity taxation. The latter arealways negative, while for public consumption the externality takes apositive sign when governments levy taxes and two goods aresubstitutes (or governments pay out subsidies and two goods arecomplements; see Eq. (8)). The last term is the wage incomeexternality, which takes a positive sign if the two goods are substitutes(or a negative sign if the two goods are complements). Moreover,under the origin principle, a wage income externality arises from theemployment externality described in Proposition 1. If we assumeperfectly competitive labormarkets, only the consumption externalityoccurs.

The first-order condition for national welfare maximization (∂Wo/∂to=0) is given by

AWo

Ato= vVwto

AXo

Ato+

AX⁎oAto

!+ vVw Xo + X⁎o

� �− wXo + w − wsð ÞALo

Ato= 0:

ð19Þ

A similar condition holds for Foreign (∂Wo⁎/∂to⁎=0). The two

conditions in combination determine the non-cooperative equili-brium under the origin principle.

3.1. Welfare properties

In order to evaluate the equilibrium tax policy determined byEq. (17) or (19), we use the Benthamite social welfare function (Wk+Wk

⁎) as an efficiency criterion.11 Evaluating ∂(Wk+Wk⁎)/∂tk and

∂(Wk+Wk⁎)/∂tk⁎ at (tk,tk⁎), which satisfies the first-order condi-

tions for national welfare maximization, we can determinewhether the equilibrium tax rate is efficient under both principles.Under the destination principle, we use Eq. (17) and obtain thefollowing:

A Wd + W⁎d

� �Atd

jequilibrium

=AW⁎

d

Atdjequilibrium

= w − wsð ÞAL⁎d

Atdb 0:

Under the origin principle, we use Eqs. (13) and (19) and obtainthe following:

A Wo + W⁎o

� �Ato

jequilibrium

=AW⁎

o

Atojequilibrium

= w w − wsw + vVt⁎o

� �AL⁎oAto

− wX⁎o :

The equations for Foreign are similar. When the marginal utility ofthe public good is sufficiently large, the tax rate is positive. In this case,

11 The validity of this welfare criterion is ensured by equalization of the marginalutility of income for both countries. In fact, with quasilinear utilities, they are bothequal to 1.

we can conclude that A Wo + W⁎o

� �=Ato jequilibrium b 0 if two goods are

complements (as ∂Lo*/∂tob0). If the tax rate is negative or two goodsare substitutes, the non-cooperative outcome is ambiguous. We canmake the following proposition.

Proposition 2. Under the destination principle, tax rates under non-cooperative equilibrium are higher than the optimal level. Underthe origin principle, tax rates under non-cooperative equilibriumare higher than the optimal level if the tax rate is positive and twogoods are complements. Otherwise, the comparison between the non-cooperative and social outcomes is ambiguous.

Proposition 2 is based directly on the externalities described inEqs. (16) and (18). Under the destination principle, each country'staxation reduces labor demand in the other. Governments do notinternalize the negative effect on welfare abroad and set inefficientlyhigh tax rates. In this case, downward harmonization would bewelfare enhancing. Under the origin principle, a similar mechanismleads to a non-cooperative equilibrium with inefficiently high taxeswhen goods are complements, if tax rates are positive. However, in theremaining cases the externalities act in the opposite directions and thenon cooperative equilibrium is ambiguous.12

4. More results on destination and origin principle comparisons

In this section, we adopt a quadratic utility function13 whosetractability allows us to be more precise about the sign and size ofthe net externalities, to derive explicit expressions for the tax ratesand “rank” destination and origin principles in terms of employmentand welfare.14 We also discuss how endogenization of wagedetermination changes the key results of the model.

4.1. Quadratic preferences: consumption and welfare

Here, we assume that the utility function takes the followingquadratic form:

U X;Y ; Z;Gð Þ = a X + Yð Þ− b − c2

X2 + Y2� �

− c2

X + Yð Þ2 + Z + 1 + vð ÞG;ð20Þ

where a, b, and c are constants satisfying aN0 and bN |c|. a is thepreference intensity for X and Y, while bN |c| implies that consumersare biased toward dispersed consumption of the two goods. For thesake of simplicity, we describe the marginal utility of the publicgood as the first-order approximation of the function v(∙), that is,1 + v, where v is a non-negative constant. The case in which v iszero can be interpreted as the case of a lump-sum transfer. Anegative v implies that the marginal utility of the public good is lessthan the marginal utility of income. In this case, governmentswould prefer redistribute lump sum transfers rather than providethe public good. Therefore, it is sufficient to consider only a non-negative v. Note that (i) the quadratic utility is not homothetic, and(ii) the two goods, X and Y, are substitutes (complements) if cN0(cb0).

rates) the positive public consumption externality counterbalances the negativeprivate consumption and wage income externalities.13 This type of utility function is often used in New Economic Geography. See, e.g.,Ottaviano et al. (2002) and Picard and Zeng (2005).14 While results in the previous section hinge on the assumption of homotheticpreferences, the quadratic utility also enables us to extend our analysis to a case ofnon-homothetic preferences.

944 S. Moriconi, Y. Sato / Journal of Public Economics 93 (2009) 939–949

The firms' labor requirements are as follows (the derivation ispresented in Appendix B):

Ld = 2A − B − Cð Þ w 2 + td + t⁎d� �h i

; ð21Þ

Lo = 2 A − Bw 1 + toð Þ + C w 1 + t⁎o� �h i

;

where A, B, and C are defined as

A =a

b + c; B =

bb2 − c2

; C =c

b2 − c2:

FromEq. (21), we conclude that even in the case of a quadratic utility,commodity taxation produces the employment externality described inProposition 1. Our analysis is valid when w b a b b + cð Þ= 2. Theseinequalities ensure that under both principles, individuals consumepositive quantities of both goods (i.e., XkN0 and YkN0) and that labordemand is lower than labor supply (i.e., Lkb1). The sufficiently largeendowment Z guarantees that the numeraire is consumed (i.e., ZkN0).Hereafter, we assume that w b a b b + cð Þ= 2 and that Z is sufficientlylarge.

Substituting Eq. (20) into Eq. (15), we obtain

Wd = 2a − b + cð ÞXd½ �Xd + w − wsð ÞLd + ws + Z + 2w vtd − 1ð ÞXd;

ð22Þ

Wo = −b X2

o + Y2o

� �2

+ a Xo + Yoð Þ− cXoYo + w − wsð ÞLo + ws

+ Z + w 1 + vð ÞtoX⁎o + vto − 1ð ÞXo − 1 + t⁎o� �

Yoh i

;

wherein we use Xd=Yd (see Eq. (36) in Appendix B).

4.2. Cooperative tax policy

Before turning to the non-cooperative tax game, we need toderive the optimal cooperative tax rate to use as a benchmark. AsHome and Foreign are symmetric, we can derive the cooperative taxchoice by maximizing the Benthamite social welfare function (Wd+Wd

⁎).15 The first-order conditions for social welfare maximizationare

A Wd + W⁎d

� �Atd

=A Wd + W⁎

d

� �At⁎d

= 0:

Solving these conditions yields a cooperative tax rate tc asfollows:

tc =v a − wð Þ− w − wsð Þ

w 1 + 2vð Þ : ð23Þ

The optimal tax rate increases with the net benefit from individualconsumption, a − wð Þ, and decreases with the size of the wagepremium, w − wsð Þ. Note that the sign of tc also depends on themarginal utility v of the public good. In particular, a sufficiently largemarginal utility (v N w − wsð Þ = a − wð Þ) leads to a positive tax rate(tcN0).16

15 Here, we derive the cooperative tax rate under the destination principle, althoughthe origin principle would make no difference because under cooperative tax policy,the destination and origin principles are equivalent.16 Lockwood (2001) and Haufler and Pflüger (2007) obtain similar results inimperfect competitive settings.

4.3. Non-cooperative tax policy

Solving first-order conditions for national welfare maximization(∂Wd/∂td=0 and ∂Wd

⁎/∂td⁎=0), we obtain non-cooperative tax ratesunder the destination principle:

td = t⁎d =v a − wð Þ− w − wsð Þ= 2

w 1 + 2vð Þ : ð24Þ

Comparing Eq. (24) with Eq. (23), we can see that the countries setan inefficiently high tax rate. This is because, as shown in Eq. (21),national governments do not internalize the negative impact ofdomestic taxation on foreign employment.

The quadratic utility allows us to derive the externalities explicitly.From Eqs. (18) and (22), we obtain

AWo

At⁎ojto = t⁎o = tc

=2cw 1 + vð Þ a − wð Þv − w − wsð Þ½ �

b2 − c2� �

1 + 2vð Þ

− w a − wð Þ 1 + vð Þ + w − wsð Þ½ �b + cð Þ 1 + 2vð Þ +

2cw w − wsð Þb2 − c2

=w a − ws + v a − wð Þ½ � 1 + 2vð Þc − b½ �

b2 − c2� �

1 + 2vð Þ ;

ð25Þ

where the partial derivative is evaluated at the cooperative tax rate, thatis, to=to⁎=tc. The first term of the first line of Eq. (25) is the publicconsumption externality, which takes a positive sign when cN0(negative sign when cb0) if tcN0. The second term is the negativeprivate consumption externality and the third term is the wage incomeexternality, which takes a positive sign when cN0 (negative sign whencb0). The second line of Eq. (25) implies thatwhen cb0, all externalitiesare negative. When cN0, the net externality is positive if and only ifv N b − cð Þ= 2c. A larger v amplifies the effect of the positive publicconsumption externality relative to private consumption and wageincome externalities. A sufficiently large v guarantees a positive netexternality.

Solving the first-order conditions for national welfare maximiza-tion (∂Wo/∂to=0 and ∂Wo

⁎/∂to⁎=0), we obtain the following non-cooperative tax rates:

to = t⁎o =a − wð Þ b − cð Þ 1 + 2vð Þ− 2b w − wsð Þ

w 3 + 4vð Þb − 1 + 2vð Þc½ � : ð26Þ

Comparing this with tc, we have

tc − to =w − wsð Þ + 1 + vð Þ a − wð Þ½ � 1 + 2vð Þc − b½ �

w 1 + 2vð Þ 3 + 4vð Þb − 1 + 2vð Þc½ � ; ð27Þ

which implies that

sgn tc − to½ � = sgnAWo

At⁎ojto = t⁎o = tc

" #

= sgn 1 + 2vð Þc − b½ �:ð28Þ

When the two goods are complements, the net externality Eq. (25)is negative and, from Eq. (28), consumption taxes are inefficientlyhigh. When goods are substitutes, the sum of positive publicconsumption andwage income externalities out balances the negativeprivate consumption externality in Eq. (25) when the marginal utilityv of the public good is larger than (b−c)/2c. The consequent positivenet externality leads to an inefficiently low tax rate.

We can summarize the arguments in this section in the propositionbelow.

17 This is similar to the objective of a utilitarian union with a fixed membership andrisk averse members (see Huizinga (1993)).

945S. Moriconi, Y. Sato / Journal of Public Economics 93 (2009) 939–949

Proposition 3. Under the destination principle, tax rates in a non-cooperative equilibrium are higher than the optimal level. Under theorigin principle, tax rates in a non-cooperative equilibrium are higherthan the optimal level when the goods are complements. If the goods aresubstitutes, tax rates in a non-cooperative equilibrium are higher (lower)than the optimal level if the marginal utility of the public good issufficiently small (large).

Proposition 3 complements Proposition 2. We were unable aboveto derive all the conditions determining the sign of net externalityunder the origin principle. Employing the quadratic utility shows that,under the origin principle, the marginal utility of the public gooddetermines the welfare properties of commodity taxation.

4.4. Wage premium, unemployment and welfare

The key feature of our model is the fixed wage and resultingunemployment. In this section, we show that the welfare andemployment evaluation of the two principles depends on the size ofthe distortion caused by a fixed wage. In particular, we prove that theorigin principle is superior to the destination principle when the wagepremium is high. This result holds true for an arbitrary non-negativevalue of v. For expositional simplicity, we analyze only the case of alump-sum transfer (i.e.,v = 0). The general case with v N 0 is de-scribed in Appendix C.

Substituting v = 0 into Eqs. (24) and (26), we have

td N tofw − ws N ω̂t N 0; ð29Þ

where

ω̂tu2 a − wsð Þ b − cð Þ

3b − c:

Due to symmetry of the two countries, in a non-cooperativeequilibrium under either principle, tax rates are the same in bothcountries. Hence, Eq. (21) implies that

td N to f Ld b Lo f 1− Ld N 1− Lo: ð30Þ

As the unemployment rate is 1−L, we can summarize theseresults in the following proposition.

Proposition 4. In the presence of a lump-sum transfer, the unemploy-ment rate is higher under the destination principle than under the originprinciple if and only if the wage premium is higher than ω̂t .

One must beware of overemphasizing the impact of consumptiontaxes on unemployment. Our framework, in the spirit of Nickell andLayard (1999), permits us to note merely that consumption taxes haveinteresting “side effects” on unemployment and that the size of theseeffects might differ under the destination and origin principles.

Differences in unemployment reflect similar differences inwelfare,which depend on the tax rate, as follows:

Wd b Wo f td N to: ð31Þ

Eqs. (29) and (31) imply the following (formal derivation andproof are presented in Appendix C).

Proposition 5. In the presence of a lump-sum transfer, welfare is higherunder the origin principle than under the destination principle if and onlyif the wage premium is higher than ω̂t .

A higher wage premium reinforces the employment externality.Moreover, for a given wage premium, the employment externality isgreater under the destination than under the origin principle, that is,

|∂Ld/∂td⁎|N |∂Lo/∂to⁎|. To measure the distortion caused by the bindingfixed wage under either principle, we look also at the shadow price of(i.e., changes in the social welfare caused by) relaxing the constraint ofa fixed wage (see Drèze and Stern (1987)). Under either principle, areduction inw increases employment and social welfareWk+Wk⁎, butby different amounts. In fact, we have

−A Wd + W⁎

d jequilibrium� �

Aw

24

35− −

A Wo + W⁎o jequilibrium

� �Aw

24

35=

w−ws

b + cN 0;

which implies that under the destination principle the distortion islarger than under the origin principle, and that the difference betweenthe two increases with the wage premium. When the wage premiumis low, the employment externality is weak, and under the originprinciple, the effect of the consumption externality is strong. In thiscase, the destination principle is superior to the origin principle.Whenthe wage premium is high, the employment externality is prominentand, under the destination principle, the net externality is strongerthan under the origin principle. In this case, the origin principle issuperior to the destination principle.

In the presence of a large distortion in the labor market, from awelfare viewpoint, our analysis upholds the origin principle. This is inline with results obtained under the assumption of a perfectcompetitive labor market: when there is a (sufficiently high) wagepremium in the economy, a non-cooperative tax policy is moreefficient under the origin principle than under the destinationprinciple, even in the absence of firms' market power.

4.5. Discussion on wage determination

Thus far, we have assumed that the wage rate is fixed. Thisassumption reflects only some of the reality and simplifies observa-tion of the effects of labor market distortions on governments'(commodity) tax setting. A more realistic modeling of unemploy-ment requires a mechanism to determine endogenous wages. In thissection, we use a union model to show that, in our framework,employment externalities persist even when we allow for endogen-ous wages.

Let us assume that the wages in each country are set, non-cooperatively, by unions that maximize insider rents (see McDonaldand Solow (1981)):17

x w; Lð Þ = L w − wsð Þ: ð32Þ

We impose a timing. First, governments choose their tax rates.Second, the union chooses the wage rate for its country. Finally, firmsdecide about employment levels.

At given tax rates, the union chooses the wage rate w, whichmaximizes Eq. (32) anticipating firms' andmarket responses, that is, itmaximizes Eq. (32) with respect to w subject to

Ld = 2A − 2 + td + t⁎d� �

Bw − Cw⁎� �

; ð33Þ

Lo = 2 A − Bw 1 + toð Þ + Cw⁎ 1 + t⁎o� �h i

;

where we exploit the fact that pX=w and pY⁎=w⁎. As in Eq. (21), theforeign tax rate under the destination principle (the origin principle)has a negative (positive) direct effect on employment. However,when the wage rate is endogenous, taxes have an additional indirect

946 S. Moriconi, Y. Sato / Journal of Public Economics 93 (2009) 939–949

effect on employment via wage rates. Here, wk and wk⁎ result from thefirst-order conditions Axk = Awk = 0 and Ax⁎

k = Aw⁎k = 0 with k=d,o:

wd =1

2B − CBws +

2A

2 + td + t⁎d

!;

wo =A

2B − Cð Þ 1 + toð Þ +Bws

4B2 − C2 2B + C1 + t⁎o1 + to

!" #: ð34Þ

Symmetric expressions hold for wd⁎ and wo⁎.18 ∂wd/∂td⁎b0 impliesthat a foreign tax increase has a positive indirect effect on employ-ment via wage changes (note that BNC) in the case of the destinationprinciple. Under the origin principle, ∂wo/∂to⁎N0 implies that aforeign tax increase has a negative indirect effect on employment.Hence, under either principle, the indirect effect of commoditytaxation on employment weakens the direct employment externality.Substituting Eq. (34) into Eq. (33) and differentiating the latter withrespect to tk⁎, we have

ALdAt⁎d

= −Bws B − Cð Þ2B − C

b 0;

ALoAt⁎o

=2B2Cws

4B2 − C2 N 0 if two goods are substitutesresp: b 0 if they are complementsð Þ:

With endogenous wages, the direct effect of taxation stilldominates the indirect effect, and the overall employment externalityhas the same sign as in Proposition 1.

5. Concluding remarks

This paper analyzed commodity tax competition in a fullycompetitive product market and an imperfectly competitive (becauseof a binding fixed wage) labor market. We show that commoditytaxation causes an employment externality with different signsdepending on whether a destination or an origin principle applies.While tax competition leads to inefficient tax rates under eitherprinciple, we found that the origin principle guarantees lowerunemployment and higher welfare when the fixed wage is high.Finally, we show that the employment externality applies in astandard union model of wage determination.

Our results have some policy implications for the design of VAT inthe EU. The EC study on wage developments and labor marketperformance highlights the low flexibility of real wages to unemploy-ment; it shows that employment is more responsive than real wages toasymmetric shocks in the EU15 (DGEFA, EC (2005)). This observationprovides some empirical grounds for the view that underpins thispaper: that labor market adjustments in EU countries are achieved byemployment rather than wage changes. The main policy implicationfrom our analysis is that in the EU, a destination-based VAT could becostly, including in terms of causing higher unemployment. If nationalauthorities want to continuewith the destination principle, they shouldencourage policies directed towards wage flexibility.

Although the idea that governments should design their VATsystems to take account of labor market distortions may at first sightbe puzzling, its advantages become clearer when we account for thevalue of these distortions in terms of lost consumption and employ-ment. An obvious objection to this scheme would be that national

18 We focus on national union power; i.e., we do not consider the case of wage rateschosen by international trade unions that maximize global rents Uk+Uk⁎. Nationalunion decisions produce a positive private consumption and employment externalityon union welfare in the other country. Thus, equilibrium wages are lower than theywould be if they were chosen by international trade unions (see also Driffil and van derPloeg (1993)).

governments might implement direct policies, such as wage subsidiesor tax credit schemes, to reduce firms' costs. These measures mightseem attractive for alleviating unemployment since they would have adirect effect on firms' hiring policies and encourage workers'participation in the labor market (see also Daveri and Tabellini(2000)). In the 1990s, many European countries (e.g., Netherlands,Spain, the UK) subscribed to this view, gradually shifting their taxburdens from direct to indirect taxation (Nickell and van Ours, 2000).However, the current economic and (to a lesser extent) politicalintegration are reducing countries' freedom to implement such policyinstruments. These effects could be regarded by the EU authorities ascompetition-distorting state aids (see the recent EC recommendationsIP/05/243 and IP/06/640 to France and Italy) while the EC iscurrently looking at the design of an “employment friendly VAT”(European Commission citeEC).

Our model is very simple and can be extended in many directions.Introducing firm' market power would make it more realistic andincrease its comparability with the theoretical frameworks developedin other studies (e.g., Nickell and Layard (1999), Belot and van Ours(2004)). Considering the use of direct and indirect taxation combinedwould make it possible to study the impact on employment of shiftingthe tax burden from the latter to the former. It would also be worthconsidering the presence of asymmetries between countries withrespect to aspects such as population size and technology. Finally,since unemployment mainly involves unskilled workers, a productionfunction that includes both skilled and unskilled labor could beconsidered. All these important and interesting topics are left forfuture research.

Acknowledgements

We gratefully acknowledge the useful comments from PierrePestieau and two anonymous referees. We also extend special thanksto Kristian Behrens, Koichi Futagami, Etienne Lehmann, Pierre Picard,and Gianmarco I.P. Ottaviano for the intensive discussions andsuggestions at the different stages in our research. We received usefulcomments and suggestions from Antonio Ciccone, Domenico DelliGatti, Nelly Exbrayat, Paolo Ghinetti, Saileshsingh Gunessee, JeanHindriks, Junichiro Ishida, Shingo Ishiguro, Marco Lossani, ClaudioLucifora, GuyMichaels, PiergiovannaNatale,Michael Pflüger, StéphaneRiou, Asa Rosen, Takashi Shimizu, Henry Tulkens, and KazuhiroYamamoto.We are grateful to the organizers of the IV Brucchi LuchinoWorkshop, the II CORE Summer School on Heterogeneity in SocialOrganizations, the ZEW Summer Workshop on EU Countries in FiscalCompetition, the invited seminar at CREUSET — Universitè JeanMonnet in Saint-Etienne, the CEP Labor Market Workshop, and theOEIO meeting held at Osaka University. The first version of this paperwas written during a visit to CORE, Universitè Catholique de Louvain,and we thank the department for its hospitality. The first authoracknowledges DEFAP for the financial support and Jean Hindriks andMassimo Bordignon for the cooperation that made the author's stay atCORE possible. The second author acknowledges the financial supportfrom MEXT and JSPS (Japan) through the Grant-in-Aid for YoungScientists (B), Scientific Research (S), and Scientific Research (B). Theusual disclaimer applies.

Appendix A

Proof of Proposition 1. Under the origin principle, ∂Lo/∂tob0 isderived directly from Eqs. (8) and (13). Under the destinationprinciple, Eqs. (6), (11), and (12) lead to

ALd =w

u − uð Þ:

Atd jX j YY XY

947S. Moriconi, Y. Sato / Journal of Public Economics 93 (2009) 939–949

Thus, showing that uYYbuXY is equivalent to proving that ∂Ld/∂tdb0. Because u(X,Y) is assumed to be homothetic, we have

uX

uY= m

YX

� �;

where m'N0, which is ensured by the concavity of u(X,Y). Eq. (5)implies that

mYX

� �=

qXqY

;

which yields

Y = Xm−1 qXqY

� �:

Therefore, we obtain

AYAqX

=AXAqX

m−1 +X

qYmV;

AYAqY

=AXAqY

m−1 − qXXq2YmV

:

Adding both sides, we have

AYAqX

+AYAqY

=AXAqX

+AXAqY

� �m−1 +

1qY

− qXq2Y

!XmV

:

In a symmetric equilibrium where qX=qY, this reduces to

AYAqX

+AYAqY

=AXAqX

+AXAqY

� �m−1

:

Hence, we obtain

sgnAYAqX

+AYAqY

= sgn

AXAqX

+AXAqY

fsgn uXX − uXY½ � = sgn uYY − uXY½ �:

Here, let us assume that uXXNuXY. Then, uYYNuXY holds and leads touXXuYYbuXY

2 because, by assumption, uXXb0 and uYYb0. This contra-dicts the concavity of u(X,Y). Therefore, we have uXXbuXY and uYYbuXY,which shows that ∂Ld/∂tdb0.

Regarding the employment externality, we have

ALoAt⁎o

=AXo

AqY+

AX⁎oAq⁎Y

!w

under the origin principle. From Eq. (6), we can see that this is positiveif X and Y are substitutes (i.e., uXYb0) and negative if they arecomplements (i.e., uXYN0). Under the destination principle, Eqs. (6)and (11) imply that in a symmetric equilibrium,

ALdAt⁎d

=wjX j uYY − uXYð Þ b 0:

Appendix B. Derivation of labor requirements underquadratic utility

Workers maximize their utility Eq. (20) under the budget con-straint (3). The first-order conditions for the maximization yield

X = A − BqX + CqY ; B1ð Þ ð35Þ

Y = A + CqX − BqY ;

Zh = Ih − qXX − qYY ;

where A, B, and C are defined as

A =a

b + c; B =

bb2 − c2

; C =c

b2 − c2:

Substituting Eqs. (4) and (9) into Eq. (35), we obtain the workers'demand for X, Y, and Z in Home under the destination principle:

Xd = Yd = A − 1 + tdð Þwb + c

; B4ð Þ ð36Þ

Zh;d = Ih − w 1 + tdð Þ Xd + Ydð Þ:

The demand functions for Xd⁎, Yd⁎, and Zd⁎ in Foreign are obtained

in the same manner. Similarly, we obtain those under the originprinciple:

Xo = A − Bw 1 + toð Þ + C w 1 + t⁎o� �

; B5ð Þ ð37Þ

Yo = A + C w 1 + toð Þ− Bw 1 + t⁎o� �

;

Zh;o = Ih − w 1 + toð ÞXo + 1 + t⁎o� �

Yoh i

:

Again, Xo⁎, Yo⁎, and Zo⁎ in Foreign are obtained similarly.Substituting Eqs. (36) and (37) into Eq. (11), we obtain the firms'

input requirements under the destination and origin principles. Thefirms' labor requirements are as follows:

Ld = 2A −w 2 + td + t⁎d� �

b + c ;

Lo = 2 A − Bw 1 + toð Þ + Cw 1 + t⁎o� �h i

:

Appendix C. Wage premium, unemployment, and welfare withpublic good provision (v N 0)

In a non-cooperative equilibrium, the tax rate is the same in bothcountries under either the destination or the origin principle. Hence,Eq. (21) implies that

td N to f Ld b Lo f 1− Ld N 1− Lo: C1ð Þ ð38Þ

As the unemployment rate is 1−L, a lower tax rate implies a lowerunemployment rate.

It is useful to distinguish the case (i) of low marginal utility of thepublic good, that is, v V b − cð Þ= 2c, from the case (ii) of highmarginalutility, that is, v N b − cð Þ= 2c, where (i) and (ii) imply that the netexternality under the origin principle is non-positive and positive,respectively (see Eq. (25)). Because we assumed that bNc, the case ofa lump-sum transfer (v = 0) is included in (i). Note further that (i) ispossible only in the case where the goods are substitutes (cN0), andthe case of product complements is included only in (ii).

In (i), from Eqs. (24) and (26), we have

td N to if and only if w − ws N ω̂t z 0; C2ð Þ ð39Þ

where

ω̂tu2 a − wsð Þ 1 + vð Þ b − 1 + 2vð Þc½ �

1 + 2vð Þ 3b − 1 + 2vð Þc½ � :

Here, we used the fact that v V b − cð Þ= 2c implies that 3b −1 + 2vð Þc N b − 1 + 2vð Þc z 0. In (ii), (27) implies that tcN to because1 + 2vð Þc − b N 0. Combined with Eq. (24), this leads to tdN to. Fromthese results and Eq. (30), we obtain the following proposition.

948 S. Moriconi, Y. Sato / Journal of Public Economics 93 (2009) 939–949

Proposition C1. Let us consider the quadratic utility. We assume thatthe goods are substitutes. When the net externality under the originprinciple is non-positive, the unemployment rate is higher under thedestination principle than under the origin principle if and only ifw − ws N ω̂t . When it is positive, the unemployment rate is alwayshigher under the destination principle than under the origin principle.When the goods are complements, the unemployment rate is alwayshigher under the destination principle than under the origin principle.

We now turn to the welfare comparison of the destination andorigin principles. Straightforward but tedious calculations show that

Wd − Wo = − w td − toð ÞΘb + c

; C3ð Þ ð40Þ

where

Θu − 2 a − wð Þv + 2 w − wsð Þ + td + toð Þw 1 + 2vð Þ:

Evaluating Θ at the equilibrium values of td and to, we can see that

Θ jequilibrium N 0 if and only if w − ws N ω̂W ; C4ð Þ ð41Þ

where

ω̂Wu −2 a − wsð Þ 1 + vð Þ b − 1 + 2vð Þc½ �b 3 + 2vð Þ + c 4v2 − 1

� � :

In (i), we have ω̂W V 0, and hence, Θ|equilibriumN0 because b −1 + 2vð Þc z 0. Therefore, we have

sgn Wd − Wo½ � = − sgn td − to½ �: C5ð Þ ð42Þ

From Eq. (39), it is shown that WdbWo if and only if w − ws N ω̂t .In case (ii), we know that tdN tcN to. This, combined with Eq. (40),

yields

sgn Wd − Wo½ � = − sgn Θ½ �:

In this case, ω̂W N 0, implying thatw − ws Nω̂W leads toΘ|equilibriumN0andWdbWo.

We can summarize the results regarding welfare in the followingproposition.

Proposition C2. Assume that the goods are substitutes. When the netexternality under the origin principle is nonpositive, the welfare is lowerunder the destination principle than under the origin principle if and only ifw − ws N ω̂t .When it is positive, thewelfare is lower under the destinationprinciple than under the origin principle if and only if w − ws N ω̂W.Whenthe goods are complements, the welfare is lower under the destinationprinciple than under the origin principle if and only if w − ws N ω̂W.

Propositions C1 and C2 confirm that the origin principle is superiorto the destination principle, from the viewpoint of both welfare andemployment, when the level of the wage premium (and hence theassociated unemployment rate) is high. In the case of productsubstitutes, we need to stress that in (ii), employment and welfareare no longer parallel when w − ws b ω̂W . Because the net-extern-ality in this case is positive under the origin principle, the unemploy-ment rate is always lower under the origin principle than under thedestination principle. However, when the level of the wage premiumis low, the overall distortion caused by the positive net externalityunder the origin principle is greater than that caused by the netnegative externality under the destination principle, leading to higherwelfare levels under the destination principle than under the originprinciple.

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