Tax-Driven Specialization and International Integration

In the transitional phase towards full economic integration, European countries have the possibility of re-shaping the continental geography of specialization. We develop a two-sector two-country model that shows formally how fiscal policy can be critical in promoting specialization in a phase where increasing returns are strong enough to sustain agglomeration but local barriers are too high for agglomeration to arise endogenously. We show that, in this intermediate phase, the optimal policy is to levy asymmetric taxes on the two sectors in order to induce agglomeration and therefore welfare benefits to both countries.