Market size and tax competition
Gianmarco I.P. Ottaviano,
Tanguy van Ypersele
Introduction
• With international externalities, different country
sizes, imperfect competition, and trade costs, tax
competition for mobile firms is efficiencyenhancing with respect to the free market
outcome.
• Under both scenarios, the resulting inefficiencies
in international specialization and trade flows
vanish when trade costs are low enough.
• Otherwise, only international tax coordination
can implement the efficient spatial distribution of
firms.
This paper aims to answer three
related questions
• does tax competition distort the international
allocation of capital, thus yielding an inefficient
international specialization in production?
• does tax competition distort the pattern of
international trade, thus yielding inefficient
shipment of goods across countries?
• if such inefficiencies exist, are they related to
the extent of trade integration and to the gap in
economic development between countries?
• the basic requirements that a model must
satisfy in order to tackle the questions
raised above are :
• International externalities,
• asymmetric sizes,
• imperfect competition,
• and trade costs
• While no model exists that fulfills all these
requirements
• This is the gap we want to fill with this
paper.
• The first develops a general equilibrium model in
which two countries compete for monopolistically
competitive firms.
• The second section characterizes the free
market outcome.
• In the third section, this outcome is shown to be
inefficient, unless trade costs are low enough.
• The fourth section characterizes the tax
competitive outcome.
• The fifth section shows that, unless firms are all
clustered in one country, tax competition is
efficiency-enhancing with respect to the free
market.
• The sixth section concludes.
The model
• 2 countries H and F
• 2 factors capital and labor
• We denote by s(0, 1) the equal shares of
total capital and labor belonging to country H.
 sL and (1-r)L are the numbers of workersresiding in countries H and F, respectively.
Country H is assumed to be larger than
country F; that is, s>1/2.
Preferences
The associated indirect utility function is:
Technology
• The differentiated varieties and the
homogeneous good are supplied by two
different sectors, modern and traditional.
• The modern sector under increasing returns
to scale and monopolistic competition.
• The traditional sector produces its
homogeneous good under constant returns
to scale and perfect competition.
International mobility
• While the traditional good is assumed to
be freely traded, the modern good faces
trade costs.
• Workers are immobile and supply labor
only to their countries of residence. They
can, however, invest their capital freely
wherever they want.
Free market equilibrium
• workers maximize utility given their budget
constraints
• firms maximize profits given their
technological constraints
• all markets clear
• we choose the freely traded homogenous
good as nume´raire.
• international wage is unity.
Demand
Supply
A firm producing variety i in country H maximizes profit:
For all sales to country H, equilibrium prices evaluate to:
all active firms find it worthwhile to export if and only if
Finally, it is readily verified that
Firms enter and exit freely so that profits are zero in equilibrium
By (3)(4)(5)
Market clearing
• There are four markets: for the modern and the
traditional goods, for capital and labor.
• In the modern sector, market clearing is ensured
by the profit maximizing choices of firms facing
downward sloping demand curves.
• In the traditional sector, market clearing is
granted by the fact that, as discussed above,
given quasi-linear utility, traditional consumption
absorbs any supply not used as trade cost.
Market clearing
As to capital,
the share of total capital allocated by workers to country H, so gK is capital
supply in country H.
since each firm needs one unit of capital, capital market clearing requires
Location
Efficient location
• Distortions
1. market power allows firms to price above
marginal cost by reducing the quantity
sold.
2. The second type of efficiency loss arises
in the presence of trade barriers
3. The third type of efficiency loss, which
materializes once capital flows are
allowed for.
First best
The planner chooses g in order to maximize the following social welfare
function:
Second best
• we define the second-best allocation as a
situation in which the planner is able to
assign any number of modern firms to a
specific region but is unable to use lumpsum transfers from workers to firms to
implement marginal cost pricing.
Comparison
Tax competition
• we assume that:
(i) country choices are made by two national
planners (governments);
(ii) each national planner maximizes the welfare of
its own citizens;
(iii) source-based per-unit taxes on labor and
capital are the only available policy tools and
only fixed costs (investment) can be subsidized;
(iv) each government faces an exogenously
determined budget requirement;
(v) taxation is not discriminatory (i.e., tax rates are
the same for domestic and foreign capital).
Tax competition
• The game between the two governments
takes place in two stages.
• In the first, governments simultaneously
choose their countries’ welfare maximizing
tax rates.
• In the second, firms and consumers make
their choices taking the chosen tax rates
as given.
Second-stage game: firms and
consumers
First-stage game: governments
Tax rates and firms location
it can be shown that the equilibrium tax rates are always negative for
positive t , being convex functions of trade costs. Therefore, tax
competition leads to subsidies to capital funded through taxes on
labor.
Moreover, equilibrium tax rates are monotonic functions of r. However, while
the former is increasing, the latter is decreasing in r.
Coordination needed
which is positive and smaller than (22) provided (6) holds.
• Coordination improves overall welfare, a natural
question to ask is whether it improves the
welfare of both countries.
• Since the coordinated outcome is a tax wedge,
there is a degree of freedom left. Increasing the
level of capital taxation while keeping the tax
differential at (25) allows governments to
transfer resources from the capital exporting
country to the capital-importing one. In other
words, the choice of the level of capital taxation
can be used as an indirect side payment
mechanism in order to make coordination not
only efficient but also Pareto-improving
• under tax competition the tax rate is
inefficiently high in the larger home
country and inefficiently low in the smaller
foreign one. The reason is the presence of
a fiscal externality.
Conclusion
• the policy attitude towards tax competition
should depend on the degree of trade
integration.
• at the initial stages of an integration
process, forbidding tax competition without
agreeing on tax coordination is a bad idea.