DP9969 Tax Competition with Heterogeneous Firms

Author(s): Richard Baldwin, Toshihiro Okubo
Publication Date: May 2014
Keyword(s): average productivity, firm heterogeneity, Nash equilibrium tax, spatial sorting, tax cooperation
JEL(s): H32, P16
Programme Areas: International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9969

This paper studies tax competition in an economic geography model that allows for agglomeration economies with trade costs and heterogeneous firms. We find that the Nash equilibrium involves the large country charging a higher tax than the small nation. Lower trade costs lead to an intensification of competition, a drop in Nash tax rates, and a narrowing of the gap. Since large, productive firms are naturally more sensitive to tax differences in our model, large firms are the crux of tax competition in our model. This also means that tax competition has consequences for the average productivity of the big and small nations' industry; by lowering tax rates, the small nation can attract high-productivity firms.