Working Paper: CEPR ID: DP1583
Authors: Andreas Haufler; Ian Wooton
Abstract: This paper analyses tax competition between two countries of unequal size trying to attract a foreign-owned monopolist. When regional governments have only a lump-sum profit tax (subsidy) at their disposal, but face exogenous and identical transport costs for imports, then both countries will always offer to subsidize the firm. Furthermore, the maximum subsidy is greater in the larger region. If countries are given an additional instrument (either a tariff or a consumption tax), however, then the larger country will no longer underbid its smaller rival and its best offer may involve a positive profit tax. In both cases the equilibirum outcome is that the firm locates in the larger market, paying a profit tax that is increasing in the relative size of this market and which is made greater when the tariff (consumption tax) instrument is permitted.
Keywords: tax competition; economic integration; foreign direct investment; regional location
JEL Codes: F12; F13; F15; F23; H25; H73
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| trade costs (F19) | home market bias (G15) |
| home market bias (G15) | preference for larger markets (R12) |
| country size (R12) | maximum subsidy offered (H20) |
| additional instruments (tariffs or consumption taxes) (H29) | shift in competitive landscape (L19) |
| larger market (D40) | location of foreign direct investment (F23) |
| market size (L25) | optimal profit tax (H21) |
| trade costs and market size (F12) | FDI decisions (F23) |