In equilibrium, if the public good reduces firms' costs, then tax competition must be eased. However, the more effective the public good at reducing firms' costs (ie, the higher k), the more governments are able to relax tax competition. The cost-reducing effect of the public good on an individual company is thus given by skxiθ.
Perhaps it could make an investment that enabled it to make better use of the public good.
Efficiency
Each government, in turn, is able to choose its level of taxation and provision of the public good, but obviously its country (A or B) is fixed. The first term, (p−c), measures the net private income for all firms that are independent of providing the public good according to the planner. Note that the level of public good provision is higher in one country than in another.
It is efficient for the planner to provide for the common good in one country only and encourage all businesses to locate there; ˆs = 0.
Competition in Taxes and Public Good Provision
Stage 2: The Tax Subgame
Intuitively, the greater the positive impact of the public good on profits, the higher Government B can set its tax τB above τA and still attract a given proportion of firms 1−ˆs to its country.24. For higher markets, Government B's loss in share of firms due to an increase in τB is more limited. Government B is therefore able to raise its taxes, making higher rents from each firm while keeping its share of firms constant.
At the same time, this makes country B less attractive to companies in A, so that government A is able to increase its taxes and charge higher rents for each company, while keeping the companies' share constant.25.
Stage 1: Level of public good provision
A higher level of provision of public goods can have a sufficiently large cost-reducing effect to make location in country B more profitable for most firms, despite higher taxation there. 26. It is a property of equilibrium that one country, say A, provides a smaller amount of the public good than the other, B. In a perfect subgame (pure strategy) equilibrium, the provision of the public good in country B is inefficiently low: xEB =1.
Proposition 3 shows that while country B provides the public good at a positive level, A provides none at all. As k increases, this x∗B increases because public goods have a greater impact on corporate profits and therefore on government rents through taxation.28. For CountryAt, this is readily apparent because it collects taxes from a positive proportion of businesses, but has no cost to public goods.
27In the proof, we show that the equilibrium in pure strategies must be asymmetric in that one government places public goods above the level of the other. We then choose to label CountriesAandB as before, as the countries with respectively low and high levels of public goods. Finally, and this is a point worth noting, we are now able to see why the level of public goods is suboptimal under relaxed tax competition.
As a result, the marginal benefit to a policymaker from delivering the public good is lower, regardless of whether that policymaker is the planner or the government. Thus, as the public good within the distribution becomes less effective in reducing business costs, and consequently tax competition becomes less smooth, the equilibrium of the tax competition game converges toward the efficient solution.31.
Policies of Tax Coordination
A Minimum Tax
Due to the concavity of rA in τA, the best that government A can do in the presence of the minimum tax is to set τµA = µ. There are similarities here with Kanbur and Keen's (1993) approach to minimum tax analysis. The minimum tax is imposed before the tax is determined within that period, creating a limited equilibrium.
This is the spirit in which the minimum tax is used for example in Keen and Marchand (1997). In the following, we will proceed from the assumption that the minimum tax is not foreseen. 37. If we write the individual levels of provision of the public good under the unexpected minimum tax constraint as xµA and xµB, then we have xµA =x∗A= 0 and xµB =x∗B =4.
Looking at (3.1), therefore, the only way efficiency can change under the imposition of a minimum tax is by changing ˆs. While the assumption that the minimum tax is unexpected is obviously limiting, we can now see why it is useful. If we keep the level of public goods provision unchanged, we can see a direct effect of the introduction of a minimum tax on taxes and thus on rents.
From Appendix A4 it is clear that this effect carries over to the situation where governments expect the introduction of the minimum tax. It is important to note that the result presented in Proposition 4 on efficiency is not strong enough to drop the assumption that the minimum tax is unexpected.
Tax Harmonization
The analysis presented in Appendix A4 shows that government B's incentive to compete in the provision of public goods (by offering public goods at a higher level than government A) is reduced by the fact that government A is limited in the extent to which it can determine his tax less than B's. As a result, while more firms are located in a country with a high share of the public good, the prevailing fact is that xµB decreases monotonically with ε and consequently efficiency decreases for the minimum tax. Kanbur and Keen (1993) do not capture this effect as they do not consider the determination of public good provision.
Related Literature and Conclusions
In standard tax competition, imposing a minimum tax increases efficiency, but unlike our paper, this is because tax competition is wasteful.42. The second situation analyzed in the literature on tax competition is one where competition promotes efficiency. Brueckner (2000) establishes a framework for examining the issues of Tiebout (differences in tastes for public services) and tax competition within a unified framework.
The model of this paper shares the feature of Tiebout tax competition that there is variation in the demands of firms for the public good. Consequently, the results of this paper contrast with those of the Tiebout tax competition literature in that more capital (i.e. a larger share of firms) is located in the higher tax country. Lockwood and Makris (2006) show that wasteful tax competition can be offset through the political process.
They also borrow the idea from the vertical product differentiation literature and apply the analogy to the level of public goods in the context of tax competition. Although tax competition is a feature of their model, they do not develop the idea of relaxed international tax competition as we do here. Wilson and Janeba (2005) show that a country's level of decentralization serves as a strategic tool during tax competition that can improve welfare.
See also Devereux, Lockwood, and Redoano (2006), who consider the interplay of horizontal and vertical tax competition. 46 A framework of horizontal (as opposed to vertical) product differentiation has also been adapted in previous work in the context of tax competition; see Justman, Thisse and van Ypersele (2005) for a recent contribution and review of the literature; see also Groenert, Wooders, and Zissimos (2006).
Appendix
- Proof of Propositions
- The Model with Congestion Costs
- The Role of θ in the Model
- Minimum Tax Anticipated
As might be expected, in the presence of congestion costs it is no longer efficient for the planner to induce all firms to locate in the same country. Applying this relation to the effective taxes in the first derivative of Ω with respect to xA, dΩ. dxA. Using the relation for effective taxes in the first derivative of Ω with respect to xB, dΩ.
But upon inspection of the first derivative, xEB is lower when congestion costs are taken into account. Now let's solve the tax subgame in light of the congestion costs. Furthermore, as we will see, xB decreases in φ (both in absolute terms and relative to xA), the effect of which further contributes to an increase in ˆsc.
Note that for given xA and xB the difference decreases in φ; xB drop effect. relative to xA) in response to an increase in φ tends to strengthen this effect. Now notice that the second term in the inner brackets on the right-hand side converges to 1/4 as φ gets large. By inspection, we can see that x∗B is positive and decreasing with respect to φ (same as the value in Proposition 3 for φ = 0).
That is, the (negative) term inφ in brackets is greater in dΩ/dxB than in drB/dxB. In what follows, we show that even when the minimum tax is assumed, the rent for the respective governments has the same qualitative characterization as in Section 5.1, where public goods were determined. Government B's incentive to compete in public goods (by offering the public good at a higher level than government A) is reduced by the fact that government A is limited in the extent to which it is permitted to set its taxes lower than B's.
The upper and lower bounds, ε and ε, are defined in the same way as in proposition 4.
This solution for xµB(ε) is illustrated for k = 1 in Figure 3 and is used to define the non-negotiable minimum tax limit illustrated in Figure 4. 14] EUbusiness (2004); "Irish PM rejects calls for EU corporate tax harmonisation." Available online at http://www.EUbusiness.com, published 14 May 2004. Zissimos (2006) "Competition in Standards and Taxes Leviathan and Local Tax Policies: Do Local Authorities Maximize Revenue?" Working Paper E-185-95, Center for Business and Economic Research, University of Kentucky.
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