2015-04 , Center for Research on Contemporary Economic Systems, Graduate School of Economics, Hitotsubashi University
This paper analyzes tax competition between politically-motivated governments in a world economy with agglomeration forces. The well-known home-market effect, in which countries with a larger home market are attractive for firms, may be reversed as a result of tax competition played by politically-interested governments. The model economy includes trade costs, internationally mobile firms, and two countries of asymmetric size. Each national government sets its tax rate strategically to maximize the weighted sum of residents’ welfare and political contributions by owners of firms as special interest groups. It is shown that, if the governments heavily care about contributions and trade costs are low, the small country attracts a more than proportionate share of firms by setting a lower tax rate.