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This paper shows that under imperfect competition, the welfare effects of indirect tax harmonization may depend crucially on whether taxes are levied by the destination or the origin principle. In a standard model of imperfect competition, while harmonization always makes at least one country better off, and may be Pareto-improving, when taxes are levied under the destination principle (which currently applies in the European Union), harmonization of origin-based taxes (as recently proposed by the European Commission) is certain to be Pareto-worsening when the preferences in the two countries are identical, and is likely to be so even when they differ.

This paper examines the quantitative effects of the transitional system of value-added taxation for intra-EC trade between 1993 and 1997, as recently adopted by the ECOFIN-Council. First, the administration of the current destination principle and the interim solution are described. A short representation of the empirical general equilibrium model featuring seven EC regions and 14 production sectors follows. Finally, the effects of a switch to the transitional system are evaluated by using numerical simulations. The adopted provisions with regard to cross-frontier sales to final consumers open tax arbitrage possibilities which favour low tax countries at the cost of their EC partners. When decomposing welfare effects, international tax revenue shifts prove to dominate, while substitution effects have relatively little influence on economic welfare.