A tax holiday is a limited period of time during which a Multinational Enterprise (MNE) receives tax concessions, usually immediately following its investment in the host country. Tax holidays have long puzzled economists: are host countries giving away the MNE's most valuable contribution, tax revenues? Competition with other countries may explain tax concessions, but does not explain why they are temporary.

In Discussion Paper No. 25, Chris Doyle and CEPR Research Fellow Sweder van Wijnbergen view the tax schedule applied to the MNE's profits as the outcome of a sequential bargaining process. They use the 'perfect equilibrium' solution concept from game theory to show that tax holidays will emerge from such a bargaining process if a MNE incurs fixed costs upon entry.

Bargaining emerges because of the existence of 'sunk costs' - those costs which are independent of the current rate of output and are irreversible once made. Examples are the installation of a factory or the training of a work force. The basis of the results in the paper is the recognition that the existence of sunk costs creates an ex post (entry) bilateral monopoly situation.

Doyle and van Wijnbergen assume that the host country and the MNE bargain over the tax rate applied to the MNE's profits during the coming period; this bargaining is repeated in each consecutive period. Furthermore the bargaining is costly: if the host country does not fully obtain the tax rate increase it demands, it becomes 'disgruntled', which the MNE dislikes as it leads to higher operating costs. The MNE prefers to remain on good terms with the host country, since goodwill facilitates the MNE's operations.

They show that a host country will seek to exploit the MNE's commitment, manifested by the initial capital outlays, by pushing for higher tax rates. The MNE has several choices. It may acquiesce; it may reject the demand and suggest a lower tax rate, or it may decide to leave the country altogether, moving to another country which offers a tax rate the MNE prefers. The second option is costly because the government becomes 'disgruntled'; the third because if the MNE moves, it must incur sunk costs again at its new location.

The tax rate emerging from this kind of bargaining has a dynamic structure. The host country, aware that the MNE would have to incur fixed costs again if it transferred production to another country, and aware of the costs of protracted tax negotiations, exploits this gradually by obtaining higher and higher tax rates until an upper limit is reached. After that the tax rate remains constant. The tax schedule thus includes a tax holiday, an initial period of tax concessions.

Doyle and van Wijnbergen obtain results on the length and discounted value of the tax holiday, its precise form, and how these respond to changes in fixed costs.