The Effect of Agglomeration Size on Local Taxes

Abstract

Standard tax competition models predict a 'race-to-the-bottom' of corporate tax rates when firms are mobile. Recent theoretical literature has qualified this view by offering a theoretical explanation why this extreme prediction need not occur: central regions with large clusters of economic activity are able to set positive tax rates without fearing to lose firms to peripheral regions as the firms would forego 'rents' from agglomeration economies. In this paper, we study whether local policy makers effectively tax such agglomeration rents. We test this with panel data from Swiss municipalities between 1985 and 2005. We find that large urban areas set indeed higher tax rates than small ones. This is consistent with the theoretical prediction. Within urban areas, however, municipal tax rates are unrelated to the size of economic activity in and around municipalities while they are positively related to the size of the political jurisdiction. We see this result as evidence that the standard tax competition model for asymmetric jurisdictions is at work in the competition of municipalities within an urban area. Both results are robust to controlling for reverse causality by using instrumental variables. Controlling for fixed effects in a 20 year panel is non-informative and neither supports nor contradicts these findings. As a robustness check we introduce an new measure of cluster intensity which considers the varying intensities in agglomeration economies across sectors.JEL-Code: R300, H320.

Fiscal and Economic Effects of Local Austerity

“…Larger municipalities may set higher corporate taxes than smaller ones without the loss of economic activity due to firms' agglomeration rents in more urban ares arising from, e.g., better market access and infrastructure or knowledge spillovers among competitors (Baldwin andKrugman, 2004, Borck andPfl üger, 2006), which limits firm mobility in light of tax rate increases. Focusing on the local tax setting behavior of German and Swiss municipalities, respectively, Koh et al (2013) and Luthi and Schmidheiny (2014) indeed show that larger, more urban municipalities tax agglomeration rents by levying higher corporate taxes on local firms (in response to some external shock).…”

Large and influential: Firm size and governments’ corporate tax rate choice

“…2013, Brülhart et al. 2012, Luthi and Schmidheiny 2014, Brülhart and Simpson 2018). Our paper adds to this literature by highlighting that, beyond effects related to the aggregate size of a jurisdiction's corporate activity, intra‐jurisdictional firm size heterogeneity impacts on business tax choices.…”

“…In recent years, studies focused mainly on strategic interaction in corporate tax rate choices of neighbouring jurisdictions, presenting some evidence in favour of inter-jurisdictional tax competition and a race-to-the-bottom of corporate tax rates (see, e.g., Devereux et al 2008, Overesch andRincke 2011). A recent strand of the literature qualifies this race-to-the-bottom prediction, suggesting that corporate tax competition may be mitigated by agglomeration rents, with larger jurisdictions choosing higher corporate tax rates (see, e.g., Ludema and Wooton 2000, Baldwin and Krugman 2004, Jofre-Monseny and Solé-Ollé 2012, Jofre-Monseny 2013, Koh et al 2013, Br ülhart et al 2012, Luthi and Schmidheiny 2014, Br ülhart and Simpson 2018. 8 Our paper adds to this literature by highlighting that, beyond effects related to the aggregate size 6 The relative importance of firm mobility and lobbying in driving the link between firm size and business tax choices must not necessarily correspond to the relative importance of the two channels in directly affecting local business taxes.…”

Swiss Municipal Data Merger Tool: Open‐source Software for the Compilation of Longitudinal Municipal‐level Data

“… 4 There is a large literature in public finance that analyzes local income and corporate taxes as well as local government expenditures (see, e.g., Brülhart & Jametti, 2006 , Cappelletti & Soguel, 2013 , Galletta, 2020 or Luthi & Schmidheiny, 2014 ). …”