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Tax Competition for Heterogeneous Firms with Endogenous Entry

Ronald B. Davies and Carsten Eckel

Abstract : This paper models tax competition for mobile firms that are differentiated by the amount of labor needed to cover fixed costs. Because tax competition affects the distribution of firms, it affects both relative equilibrium wages across countries and equilibrium prices. These in turn influence the equilibrium number of firms. From the social planner's perspective, optimal tax rates are harmonized, providing the optimal number of firms, and set such that income is efficiently distributed between private and public consumption. As is common in tax competition models, in the Nash equilibrium tax rates are inefficiently low, yielding underprovision of public goods. Furthermore, there exist a variety of situations in which equilibrium tax rates differ. As a result, too many firms enter the market as governments compete to be the low-tax, high-wage country. This illustrates a new distortion from tax competition and provides an additional benefit from tax harmonization.

JEL Classification: F12; F23; H25

Key Words: Tax Competition, Foreign Direct Investment, Tax Harmonization

Last updated 28 August 2014 by IIIS (Email).