Tax Competition on the Extensive and Intensive Margins

Abstract

Tax administration is costly and may discourage some governments from utilizing certain taxes, thus becoming tax havens on those particular tax bases. This paper studies the welfare implications of strategic tax setting in the presence of such zero-tax jurisdictions. We develop a tax competition model in which jurisdictions first decide whether or not to levy a tax and then decide the optimal tax rate to compete for mobile factors. We compare the competitive equilibrium to the tax rates that a central (federal) planner would set. We show that decentralized tax rates can be too low or too high depending on the number of non-adopting jurisdictions. Surprisingly, taxes are too low if the number of non-adopting jurisdictions is low and too high if the number of non-adopting jurisdictions is high. We apply our model to U.S. county sales taxes where 40% of jurisdictions do not levy a sales tax. We find that tax rates are up to 17% too low and the number of non-adopting jurisdictions is up to 28% too high compared to the social optimum.

Keywords: Tax competition, Tax havens, Commodity taxes, Public goods, Tax administration

JEL Classification: H71, H72, R50, R51