Small countries have a low corporate tax rate

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2 Small countries have a low corporate tax rate Country size and corporate tax rate of OECD countries in / 31

3 Success of some small countries Some small countries with low corporate tax rates have succeeded in attracting foreign investment. Ireland, (tax rate) = 12.5%: Hosting multinational firms of ICT and pharmaceutical industry from the U.S. Singapore, (tax rate) = 17%: Hub for multinational firms entering Asian market. 3 / 31

4 Export-oriented investment The foreign investment to these countries is mainly export-oriented. Ireland: foreign-owned firms accounted for 91% of Ireland s tradeable exports in Singapore: long tradition of export-oriented industrialization. 4 / 31

5 What we do Q. Why can some small-sized countries attract export-oriented investment by setting a low tax rate? This study tackles the question by examining tax competition b/w politically-interested governments in an economy with agglomeration forces. 5 / 31

6 Preview (1/3) Setting Tax competition b/w two countries of different size in a footloose capital version of NEG model. Capital owners as a SIG make political contributions. Governments objective: a (residents welfare) + (political contributions). 6 / 31

7 Preview (2/3) Main result If the governments heavily care about political contributions and trade costs are low, the small country attracts a more than proportionate share of firms ( reversal of the home-market effect). 7 / 31

8 Preview (3/3) Mechanism (Firm s profit) = (Local profit) + (Export profit). Because of the presence of trade costs and international oligopoly, For firms in the small country : (Local profit) < (Export profit). For firms in the large country : (Local profit) > (Export profit). Both firms prefer fewer rivals in the large country. Owners of firms lobby to attain such an industry allocation. As a result, the small country may import capital from the large country by setting a lower tax rate. 8 / 31

9 Related literature Tax competition in public finance: Small country attracts capital. Bucovetsky (1991); Wilson (1991). Tax competition in NEG: Large country attracts capital. Ludema and Wooton (2000); Baldwin and Krugman (2004); Ottaviano and van Ypersele (2005); Haufler and Wooton (2010). Exceptions: Borck et al. (2012); Miyagiwa and Sato (2014); Kato (2015). Protection for sale: Grossman and Helpman (1994, 1995); Chang (2005); Chang and Willmann (2014). 9 / 31

10 FC model (1/5) Two countries: 1 and 2. Two factors: Internationally mobile capital K and immobile labor L. (L 1, K 1 ) = (sl, sk), (L 2, K 2 ) = ((1 s)l, (1 s)k). Assume country 1 is small : s < 1/2. Two industries: Non-numéraire-homogeneous good (=modern sector) Cournot competition, trade costs. Numéraire-homogeneous good (=traditional sector) Perfect competition, no trade costs. 10 / 31

11 FC model: Demand side (3/5) From the quadratic utility function, we get linear demands: p 1 = 1 Q 1 /L 1 = 1 Q 1 /(sl), p 2 = 1 Q 2 /L 2 = 1 Q 2 /[(1 s)l]. The slope of the demand curve in country 1 is steeper than that of 2, while the intercepts are identical. The market in 1 is more competitive. 11 / 31

12 FC model: Modern firm (4/5) For firms located in country 1: π 1 p 1 q 11 + (p 2 τ)q 12. For firms located in country 2: π 2 (p 1 τ)q 21 + p 2 q 22. Firms need one unit of K to start operation. In location equilibrium, π 1 (λ 1 ) = π 2 (λ 2 1 λ 1 ). 12 / 31

13 FC model: Home-market effect (5/5) The equilibrium share of firms when 1 is small (s < 1/2) : Note that K 1 = sk. π 1 (λ 1 ) = π 2 (λ 1 ), (+) (+) {}}{{}}{ λ (1 2s) [2 τ(k + 1)] 1 = s 2τK < s. Lemma (Home-market effect) The small country obtains a less than proportionate share of firms. Intuition: Suppose λ = 1/2 p 1 < p 2 π 1 (1/2) < π 2 (1/2) λ / 31

14 Tax competition Lump sum tax/subsidy T i on each firm operating in i. After-tax profits are equalized: π 1 T 1 = π 2 T 2, λ 1 = λ 1 K + 1 2τ 2 KL (T 1 T 2 ). Tax revenues are redistributed to residents. 14 / 31

15 Political economy of tax competition We model lobbying as in Protection for sale by Grossman and Helpman (1994, 1995). 1. Capital owners as a lobbying group make contributions to their domestic government. 2. Tax rates are non-cooperatively determined by governments. 3. Firm relocation occurs. 15 / 31

16 Political economy of tax competition Welfare of workers and capital owners in i (up to constants) is W l i = CS i + TR i = (1 p i ) 2 L i /2 + T i λ i K, W c i = Π i = (π i T i )K i. By focusing on the truthful equilibria, we can rewrite the government objective as G i = a(w l i + W c i ) + C i = awi l + (1 + a)wi c ( C i = Wi c B, = a(cs i + TR i + βπ i ) ( β (1 + a)/a. a: weight on aggregate welfare, C i : contribution. 16 / 31

17 Benchmark 1: No lobbying, symmetric size Under the benevolent governments, we set a = 1: G i = CS i + TR i + Π i. Equilibrium tax rates are the solution of dg i /dt i = 0 for all i {1, 2}. When two countries are symmetric (s = 1/2), T1 n = T2 n = 4τKL [ τ τ K τ ] 4(K + 1) Tax-revenue effect: positive. Profit-income effect: negative. Consumer-price effect: negative. λ n 1 = 1/2. 17 / 31

18 Benchmark 2: No lobbying, asymmetric size When two countries are asymmetric (s < 1/2), T1 n = 4τKL [ τ τ K τ ] 4(K + 1) [ τ τ 2 T n 2 = 4τKL K τ 4(K + 1) Market-size effect modifies the first three effects. τl(1 2s)Θn 1 4(K + 1) 2 (4K + 5), ] + τl(1 2s)Θn 2 4(K + 1) 2 (4K + 5). Since firms relocate to large country 2 to save transport costs, government 2 can exploit agglomeration rents: T n 1 < T n 2. Country 1 still exports capital despite its lower tax rate: λ n 1 < s. 18 / 31

19 In the interior equilibrium, we have Proposition 1 The small country hosts a smaller share of firms than its capital share and sets a lower tax rate than the large country. The home-market effect still prevails. 19 / 31

20 Lobbying case: Key mechanism The governments objective function: The impact on profit income is dπ i dt i (1/a)G i = CS i + TR i + βπ i. = d(π ( i T i )K i πi = dt i λ i }{{}? dλ i dt i }{{} ( ) ) 1 K i Large country 2, π 2 / λ 2 < 0 ( λ 2 π D, π EX Small country 1, π 1 / λ 1 > 0 when trade costs are low. ( λ 1 π D, π EX dπ 1 /dt 1 < dπ 2 /dt 2 Gov.1 is more eager to cut taxes: T 1 << T / 31

21 Profits of a firm in the small country Firms prefer λ 1 = / 31

22 Profits of a firm in the large country Firms prefer λ 2 = 0 or λ 1 = / 31

23 Home market effect may be reversed Equilibrium tax rates: T1 = 4τKL [ K + 1 T 2 = 4τKL K + 1 T 1 < T 2. The equilibrium share of firms: (+) τ βτ 2 2 τ ] 4(K + 1) [ τ βτ 2 2 τ ] + 4(K + 1) τl(1 2s)Θ 1 4(K + 1) 2 [2(3 β)k + 5], τl(1 2s)Θ 2 4(K + 1) 2 [2(3 β)k + 5] {}}{{}}{ λ (1 2s) [K + 2 τ(k + 1) 2 2(β 1)K{1 τ(k + 1)}] = s. τk [2(3 β)k + 5] }{{} (+) If β is large enough (β < β) and trade costs are low enough (τ < τ ), then λ > s.? 23 / 31

24 Home market effect may be reversed In the interior equilibrium, we have Proposition 2 (Reverse HME) If governments care about contributions heavily (β > β ) and trade costs are low (τ < τ ), the small country obtains a more than proportionate share of firms. 24 / 31

25 If τ < τ hold, we have d T1 T 2 /dβ > / 31

26 If τ < τ hold, we have dλ 1 /dβ > / 31

27 Welfare implications λ o 1 = argmax W, W W 1 + W 2. Proposition 3 When the RHME prevails, the equilibrium share under the biased-gov.s is more socially inefficient than that under the benevolent gov.s. 27 / 31

28 Extensions: Asymmetric weight Consider asymmetric weights: β 1 β 2. The government with a higher weight decreases its tax rate more. RHME still emerges. 28 / 31

29 Conclusion Remark Q Empirical studies suggest the political weight β is small, which is inconsistent with the predictions. Not every studies report small estimates. See Mitra et al. (2006). Past empirical studies are based on trade policies, not on tax policies. Summary Capital owners in both countries seek a fewer number of firms in the large market. The small country lowers its tax rate excessively because of lobbying pressure by capital owners. The reversal of the home market effect. 29 / 31

30 Thank you for your attention! 30 / 31

31 Small countries attract foreign capital Country size and (Inward FDI stock)/(gdp) of OECD countries in / 31

32 Baldwin, R. E. and Krugman, P. R. (2004). Agglomeration, integration and tax harmonisation. European Economic Review, 48(1):1 23. Borck, R., Koh, H.-J., and Pflüger, M. (2012). Inefficient lock-in and subsidy competition. International Economic Review, 53(4): Bucovetsky, S. (1991). Asymmetric tax competition. Journal of Urban Economics, 30(2): Chang, P.-L. (2005). Protection for sale under monopolistic competition. Journal of International Economics, 66(2): Chang, P.-L. and Willmann, G. (2014). Protection for sale with heterogenous interests within industries. mimeo. Grossman, G. M. and Helpman, E. (1994). Protection for sale. American Economic Review, 84(4): Grossman, G. M. and Helpman, E. (1995). Trade wars and trade talks. Journal of Political Economy, 103(4): Haufler, A. and Wooton, I. (2010). Competition for firms in an oligopolistic industry: the impact of economic integration. Journal of International Economics, 80(2): Kato, H. (2015). The importance of government commitment in attracting firms: A dynamic analysis of tax competition in an agglomeration economy. European Economic Review, 74(C): Ludema, R. D. and Wooton, I. (2000). Economic geography and the fiscal effects of regional integration. Journal of International Economics, 52(2): / 31

33 Mitra, D., Thomakos, D. D., and Ulubaşoğlu, M. (2006). Can we obtain realistic parameter estimates for the eprotection for salefmodel? Canadian Journal of Economics, 39(1): Miyagiwa, K. and Sato, Y. (2014). Free entry and regulatory competition in a global economy. Journal of Public Economics, 118(C):1 14. Ottaviano, G. I. and van Ypersele, T. (2005). Market size and tax competition. Journal of International Economics, 67(1): Wilson, J. D. (1991). Tax competition with interregional differences in factor endowments. Regional Science and Urban Economics, 21(3): / 31