Tax Competition and Trade Protection

30 Pages Posted: 15 Dec 1999 Last revised: 2 Apr 2001

See all articles by Eckhard Janeba

Eckhard Janeba

University of Mannheim - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

John D. Wilson

Michigan State University - Department of Economics

Date Written: October 1999

Abstract

This paper reconsiders the question of whether tax competition for mobile capital leads to tax rates on capital that are too low or too high from the combined viewpoint of the competing regions (or countries in an economic union). In contrast to standard models of tax competition, both commodity trade and capital mobility is allowed to occur between the competing regions and the rest of the world. A key result of the analysis is that whether the capital taxes are too low or high depends on the degree of external trade protection. When the country's central government is free to set the tariff, tax competition leads to inefficiently low tax rates. But in the absence of a tariff, tax rates can be too high. In particular, regions may choose to subsidize capital in equilibrium as a means of inducing favorable terms-of-trade effects, but the subsidy (i.e., a negative tax) will then be too low because an increase in a single region's subsidy benefits other regions by reducing their relative quantities of subsidized capital. These results are discussed in the context of the European Union's Single Market, where non-EU firms have responded to the 'Fortress of Europe' by increasing foreign direct investment.

Suggested Citation

Janeba, Eckhard and Wilson, John D., Tax Competition and Trade Protection (October 1999). NBER Working Paper No. w7402. Available at SSRN: https://ssrn.com/abstract=193676

Eckhard Janeba (Contact Author)

University of Mannheim - Department of Economics ( email )

L7, 3-5
D-68131 Mannheim
Germany

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

John D. Wilson

Michigan State University - Department of Economics ( email )

East Lansing, MI 48824
United States

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