Does competition between regions for mobile firms, by providing local public inputs, result in an inefficient allocation? Uwe Walz and Dietmar Wellisch reconsider the basic question of the tax competition literature by modelling strategic interaction not only between regions, but also among private firms. Two regions compete for an oligopolistic firm by taxing the profits of all firms locating within their respective boundaries and using the tax revenues to provide local public inputs. The paper models imperfect competition in the output market in the spirit of Brander and Spencer (1985), Eaton and Grossman (1986), or Helpman and Krugman (1989). Contrary to these studies, however, the paper introduces firm mobility.

The basic question of the paper is whether competing regions take account of the converging and diverging forces with respect to agglomeration in a socially efficient way, when providing public inputs, or whether competition between regions induces too much (little) agglomeration and an inefficiently high (low) level of local public inputs. It is shown that the central government provides an efficient level of local inputs and induces a spatially efficient allocation of firms. The decentralised provision of local inputs by regional governments, however, leads in most cases to an inefficient allocation.