Working Paper: CEPR ID: DP6740
Authors: Kai A. Konrad; Dan Kovenock
Abstract: Countries compete for new FDI investment, whereas stocks of FDI generate agglomeration benefits and are potentially subject to extortionary taxation. We study the interaction between these aspects in a simple vintage capital framework with discrete time and an infinite horizon, focussing on Markov perfect equilibrium. We show that the equilibrium taxation destabilizes agglomeration advantages. The agglomeration advantage is valuable, but is exploited in the short run. The tax revenue in the equilibrium is substantial, and higher on "old" FDI than on "new" FDI, even though countries are not allowed to use discriminatory taxation. If countries can provide fiscal incentives for attracting new firms, this stabilizes existing agglomeration advantages, but may erode the fiscal revenue in the equilibrium.
Keywords: agglomeration; bidding for firms; dynamic tax competition; foreign direct investment; vintage capital
JEL Codes: F21; H71
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Equilibrium taxation (H29) | destabilizes existing agglomeration advantages (R11) |
| Higher taxes on old FDI (F23) | lower competitiveness in attracting new FDI (F23) |
| Higher expected tax rates (H29) | affects ability to attract new FDI (F64) |
| Agglomeration advantage (R32) | strategic disadvantage if exploited through high taxation (H29) |
| Historical stock of FDI (F21) | influences competition for new FDI (F23) |