DP6186 Competing for Capital When Labour is Heterogeneous

Author(s): Yasuhiro Sato, Jacques-Fran├žois Thisse
Publication Date: March 2007
Keyword(s): capital mobility, fiscal competition, local labour markets, reverse home market effect
JEL(s): F21, H31, J31
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6186

This paper investigates the impacts of capital mobility and tax competition in a setting with imperfect matching between firms and workers. The small country attracts fewer firms than the large one but accommodates a share of the industry that exceeds its capital share - a reverse home market effect. This allows the small country to be more aggressive and to set a higher tax rate than the large one, thus implying that tax competition reduces international inequalities. However, the large country always attains a higher utility than does the small country. Our model thus encapsulates both the 'importance of being small' and the 'importance of being large'. Last, tax harmonization benefits to the small country but is detrimental to the large one.