Tax Competition and Tax Harmonization with Evasion.

Abstract

We examine a two-jurisdiction tax competition environment where local governments can only imperfectly monitor where agents pay taxes and risk-averse individuals may choose to cross borders to pay lower taxes in a neighboring location. In the game between local authorities, when communities differ in size, in equilibrium the smaller community sets lower taxes and attracts agents from the larger jurisdiction. With identical communities, tax rates must be equal. Whenever the smaller community benefits from tax harmonization, the larger one will also. If the high-tax community chooses a monitoring policy, the local population splits into groups of tax avoidance and compliance.