Lobbying and Tax Competition in an Agglomeration Economy: A Reverse Home Market Effect

Abstract

This paper analyzes tax competition between politically-motivated governments in a world economy with agglomeration forces. The well-known home-market effect, in which countries with a larger home market are attractive for firms, may be reversed as a result of tax competition played by politicallyinterested governments. The model economy includes trade costs, internationally mobile firms, and two countries of asymmetric size. Each national government sets its tax rate strategically to maximize the weighted sum of residents' welfare and political contributions by owners of firms as special interest groups. It is shown that, if the governments heavily care about contributions and trade costs are low, the small country attracts a more than proportionate share of firms by setting a lower tax rate.

Competition for FDI and Profit Shifting

“…     . 14 Thus, the MNE prefers locating in the large country due to the home market effect. #2 Consider now the case where profit shifting opportunities exist but are equal across potential host countries, i.e.…”

“…Haufler and Wooton (1999) consider lump-sum taxes rather than ad valorem taxes. This allows them to derive slightly different expressions, but the main thrust of the arguments is the same 14. This is because + 1 −   1 + (1 −  ) is always true when   1 and 0    1.15 This is because the second term in   will also be larger than the second term in   16 The present paper treats   as exogenous, i.e.…”