Customs unions and domestic Taxes

It is well known that non-discriminatory domestic taxes and subsidies are perfect substitutes for non-discriminatory trade policies and would render useless international agreements restricting trade policy alone. We show that these instruments generally are imperfect substitutes for trade policy in a customs union. However, in one popular specification of trading patterns, access to such tax powers nevertheless renders a customs union useless. Furthermore, numerical simulations demonstrate that a union may be ineffective in many other cases, severely curtailing the potential unions that are attractive to both members. We illustrate the restrictive conditions under which a union will then form.