DP2630 Agglomeration, Integration and Tax Harmonization

Author(s): Richard Baldwin , Paul Krugman

Publication Date: November 2000

Keyword(s): Economic Geography , Trade , Tax Competition , Tax Harmonization

JEL(s): F12 , F20 , H00 , H87

Programme Areas: International Trade and Regional Economics , Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP2630_contents.asp.asp

This Paper considers tax competition and tax harmonization in the presence of agglomeration forces and falling trade costs. With agglomerative forces operating, industry is not indifferent to location in equilibrium, so perfectly mobile capital becomes a quasi-fixed factor. This suggests that the tax game is something subtler than a race to the bottom. Advanced 'core' nations may act like limit-pricing monopolists toward less advanced 'periphery' countries. Consequently, integration need not lead to falling tax rates, and might well be consistent with the maintenance of large welfare states. ‘Limit taxing’ also means that simple tax harmonization – adoption of a common tax rate – always harms at least one nation and adoption of a rate between the two unharmonized rates harms both nations. A tax floor set at the lowest equilibrium tax rate leads to a weak Pareto improvement.