Tax competition, imperfect capital mobility and the gain from non-preferential agreements

ABSTRACT

The gain to competing governments from entering into binding non-preferential tax agreements (that prevents discriminatory taxation in favor of mobile capital) depends on the extent of capital mobility between jurisdictions. In particular the gain is increasing in the cost of relocation of capital and the fraction of the domestic tax base which is relatively immobile. We show this in a symmetric model of tax competition between two governments where all capital is imperfectly mobile and differ only in their cost of relocation.

KEYWORDS:

• Tax competition
• capital mobility
• non-preferential regime

JEL CLASSIFICATIONS:

• F15
• F21
• H26
• H87

Acknowledgments

I am thankful to an anonymous referee for useful comments and suggestions. I am also thankful to Santanu Roy, Kamal Saggi, Rajat Deb and Pritha Dev for their comments and suggestions. All remaining errors are mine.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. See Wilson (1999) for a review of tax competition literature.

2. It is important to notice that a preferred treatment of foreign residents is often granted indirectly rather than directly. Ireland, for instance, levied only a 10% tax rate on corporate income in the manufacturing and financial service sectors instead of the standard rate (32%).

3. Konrad (2011) shows that competition for mobile capital decreases when competing countries don't have full information about prevailing effective tax rates which results in costly search cost.

4. In a seminal paper Zodrow and Mieszkowski (1986) show that competition for mobile capital leads to under-provision of public goods. Becker and Runkel (2012) find that efficient public good provision is obtained when a small transportation cost is introduced in Zodrow and Mieszkowski (1986) model.

5. Capital may infact move to a jurisdictions where its productivity is lower if the same is compensated through a lower tax rate.

6. Kishore and Roy (2014) and Kishore (2017) analyze scenario where a single country wishes to attract foreign investments.

7. Unlike asymmetry in size and composition of capital bases between countries, asymmetry in productivity of capital between two countries may actually increase the appeal of preferential taxation if the smaller country is also less productive. Nicolas, Steeve and Wilson (2010) argue that when one of the capital bases is perfectly mobile and the other is perfectly immobile, non-preferential regime causes the smaller country to be more aggresive in reducing taxes (smaller domestic immobile capital segment); and if the smaller country is also less productive, then it may lead to a reduction in the total output and hence the joint tax revenues of the competing countries.

8. Wang (2004) generalizes this model further, allowing for mixed startegy Nash equilibrium. His finding lends support to the main result of Janeba and Peters (1999).

9. Also see Peralta and Ypersele (2005) for tax competition among assymetric countries.

10. The introduction of asymmetry between competing jurisdictions does not necessarily overturn Keen's result on superiority of preferential tax regimes. For example, Bucovetsky and Haufler (2007) show that Keen's result holds if countries differ in size.

11. Becker and Runkel (2012) also shows that even small cost of relocation can significantly reduce competition. Also see Konrad (2011) for the effect of search cost on tax competition.

12. Among many, see for example; Butters (1977), Rosenthal (1980), Varian (1980), Deneckere, Kovenock and Lee (1992), and Narasimhan (1988).

13. See for example Janeba and Peters (1999), Wang (2004), Wilson (2005), and Nicolas, Steeve and Wilson (2010) among many.

14. This is identical to assuming that the government is Leviathan (see, Edwards and Keen 1996).

15. See Konrad (2011) for somewhat similar mixed startegy Nash equilibrium. Dasgupta and Maskin (1986) provide an example where a firm can sell to all consumers by undercutting the price charged by a competing firm by a small margin. Varian (1980) characterizes symmetric mixed strategy Nash equilibrium of a more general price competition model with n firms and free entry. Banks and Moorthy (1999) also dealt with a similar problem.

16 See Daveyjan (2014).

17. Narasimhan (1988) analyzed the situation where a fraction of consumers are loyal to one product and they are not price sensitive.

18. Klemperer (1995) analyzes a scenario where a fraction of consumers have infinite switching cost.

19. Note that under preferential regime countries set tax rates for mobile and immobile capital bases independent of each other. Putting $\lambda =1$ in $\left(2\right)$ we get $F\ge 0$, which is trivially satisfied.

20. ${\mathrm{\partial }}^2\mathrm{\Phi }/\mathrm{\partial }{\lambda }^2=-2<0.$