Sensitivity versus Size: Implications for Tax Competition

Abstract

The conventional wisdom is that big jurisdictions set higher tax rates than small jurisdictions. We show that this result is due to simplifying assumptions: the tax base is only mobile to a single competitor and the sensitivity of the base is constant. In the presence of multiple jurisdictions and a non-constant sensitivity, small jurisdictions can set higher tax rates than big jurisdictions. This result holds for commodity, capital, and profit taxes and stands in contrast to the conventional findings in the "duopolity" case, on which the literature focuses. In the case of commodity tax models, our theoretical results imply that both overall size and the population “near enough” to the border matter. An empirical application to local sales taxes shows that increases in the number of people near borders lowers tax rates and the probability of having a higher rate than neighboring jurisdictions. The population distribution may be more important than total population.

Keywords: Ramsey rule, inverse elasticity, fiscal competition, optimal taxation, spatial price competition, sales tax

JEL Classification: C7, D4, H2, H7, L1, R5