Lobbying and Tax Competition in an Oligopolistic
Industry: A Reverse Home Market EffectFormer title: Lobbying and Tax Competition in an Agglomeration Economy: A
Reverse Home Market Effect

Hayato Kato
Hitotsubashi University

March 18, 2015

Remark: Notations are slightly different from those in the final version
published in Spatial Economic Analysis.
1 / 31Small countries have a low corporate tax rate
Country size and corporate tax rate of OECD countries in 2011.

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Success of some small countries

I Some small countries with low corporate tax rates have succeeded inattracting foreign investment.
• Ireland, (tax rate) = 12.5%:
Hosting multinational firms of ICT and pharmaceutical industry fromthe U.S.
• Singapore, (tax rate) = 17%:
Hub for multinational firms entering Asian market.

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Export-oriented investment

I The foreign investment to these countries is mainly export-oriented.

• Ireland: foreign-owned firms accounted for 91% of Ireland’s tradeable
exports in 2009.
• Singapore: long tradition of export-oriented industrialization.

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What we doQ. Why can some small-sized countries attract export-orientedinvestment by setting a low tax rate ?
I This study tackles the question by examining tax competition b/w

politically-interested governments in an economy with agglomerationforces.

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Preview (1/3)

Setting
I Tax competition b/w two countries of different size in a footloose

capital version of NEG model.
I Capital owners as a SIG make political contributions.
I Governments’ objective:

a× (residents’ welfare) + (political contributions).

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Preview (2/3)

Main result
I If the governments heavily care about political contributions andtrade costs are low,
the small country attracts a more than proportionate share of firms( reversal of the home-market effect).

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Preview (3/3)

Mechanism
I (Firm’s profit) = (Local profit) + (Export profit).
I 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.

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Related literature

I Tax competition in public finance: Small country attracts capital.

• Bucovetsky (1991); Wilson (1991).
I Tax competition in NEG: Large country attracts capital.

• Ludema and Wooton (2000); Baldwin and Krugman (2004); Ottaviano and vanYpersele (2005); Haufler and Wooton (2010).
 Exceptions: Borck et al. (2012); Miyagiwa and Sato (2014); Kato (2015).
I Protection for sale:• Grossman and Helpman (1994, 1995); Chang (2005); Chang and Willmann(2014).

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FC model (1/5)

I Two countries: 1 and 2.
I Two factors: Internationally mobile capital K and immobile labor L.

(L1 , K1 ) = (sL, sK ), (L2 , K2 ) = ((1 − s)L, (1 − s)K ).
Assume country 1 is small : s < 1/2.
I Two industries:• Non-numéraire-homogeneous good (=modern sector)
Cournot competition, trade costs.
• Numéraire-homogeneous good (=traditional sector)
Perfect competition, no trade costs.

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FC model: Demand side (3/5)

I From the quadratic utility function, we get linear demands:

p1 = 1 − Q1 /L1 = 1 − Q1 /(sL),p2 = 1 − Q2 /L2 = 1 − Q2 /[(1 − s)L].
I 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.

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FC model: Modern firm (4/5)

I For firms located in country 1:

π1 ≡ p1 q11 + (p2 − τ )q12 .
I For firms located in country 2:

π2 ≡ (p1 − τ )q21 + p2 q22 .
I Firms need one unit of K to start operation.
I In location equilibrium,π1 (λ1 ) = π2 (λ2 ≡ 1 − λ1 ).

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FC model: Home-market effect (5/5)
I The equilibrium share of firms when 1 is small (s < 1/2) :π1 (λ1 ) = π2 (λ1 ),(+)(+)

z }| { z}|{(1 − 2s) [2 − τ (K + 1)]< s.
⇔ λ̃1 = s −2τ K
I Note that K1 = sK .

Lemma (Home-market effect)

The small country obtains a less than proportionate share of firms.


I Intuition: Suppose λ = 1/2 → p1 < p2 → π1 (1/2) < π2 (1/2) → λ1⇓.
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Tax competition

I Lump sum tax/subsidy Ti on each firm operating in i.
I After-tax profits are equalized:

π 1 − T1 = π 2 − T2 ,K +1⇔ λ1 = λ̃1 − 2 (T1 − T2 ).
2τ KL
I Tax revenues are redistributed to residents.

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Political economy of tax competition

I We model lobbying as in “Protection for sale” by Grossman andHelpman (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.

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Political economy of tax competition
I Welfare of workers and capital owners in i (up to constants) is

Wil = CSi + TRi = (1 − pi )2 Li /2 + Ti λi K ,Wic = Πi = (πi − Ti )Ki .
I By focusing on the “truthful equilibria”, we can rewrite thegovernment’ objective as
Gi = a(Wil + Wic ) + Ci
= aWil + (1 + a)Wic= a(CSi + TRi + βΠi )I a: weight on aggregate welfare,(∵ Ci = Wic − B,(∵ β ≡ (1 + a)/a.

Ci : contribution.

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Benchmark 1: No lobbying, symmetric size
I Under the benevolent governments, we set a = 1:

Gi = CSi + TRi + Πi .
I Equilibrium tax rates are the solution of dGi /dTi = 0 for alli ∈ {1, 2}.
I When two countries are symmetric (s = 1/2),

T1n = T2n =2−ττ4τ KL
τ− −K +1
2 4(K + 1)

I Tax-revenue effect: positive.
I Profit-income effect: negative.
I Consumer-price effect: negative.

→ λn1 = 1/2.
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Benchmark 2: No lobbying, asymmetric size

I When two countries are asymmetric (s < 1/2),


4τ KL
τ
2−τ
τ L(1 − 2s)Θn1
τ− −−,
K +1
2 4(K + 1)
4(K + 1)2 (4K + 5)τ2−τ
τ L(1 − 2s)Θn24τ KL
τ− −+.
T2n =K +1
2 4(K + 1)
4(K + 1)2 (4K + 5)
T1n =I Market-size effect modifies the first three effects.
I Since firms relocate to large country 2 to save transport costs,
government 2 can exploit agglomeration rents: T1n < T2n .
I Country 1 still exports capital despite its lower tax rate: λn < s.
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I In the interior equilibrium, we haveProposition 1

The small country hosts a smaller share of firms than its capitalshare and sets a lower tax rate than the large country.


I The home-market effect still prevails.

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Lobbying case: Key mechanism
I The governments’ objective function:(1/a)Gi = CSi + TRi + βΠi .
I The impact on profit income isd(πi − Ti )KidΠi==dTi
dTi∂πi dλi−1 Ki∂λi dTi|{z} |{z}?

(−)

I Large country 2,∂π2 /∂λ2 < 0 (∵ λ2 ⇑→ πD ⇓⇓, πEX ⇑I Small country 1,∂π1 /∂λ1 > 0 when trade costs are low.
(∵ λ1 ⇑→ πD ⇓, πEX ⇑⇑→ dΠ1 /dT1 < dΠ2 /dT2 → Gov.1 is more eager to cut taxes: T1 << T2 .

20 / 31Profits of a firm in the small country

Firms prefer λ1 = 1.

21 / 31Profits of a firm in the large country

Firms prefer λ2 = 0 or λ1 = 1.

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Home market effect may be reversed
I Equilibrium tax rates:4τ KLβτ2−ττ L(1 − 2s)Θ∗1
τ−−−,K +1
24(K + 1)
4(K + 1)2 [2(3 − β)K + 5]4τ KLβτ2−ττ L(1 − 2s)Θ∗2T2∗ =τ−−+K +124(K + 1)
4(K + 1)2 [2(3 − β)K + 5]
T1∗ =→ T1∗ < T2∗ .
I The equilibrium share of firms:?

(+)}|{z }| { z2(1−2s)[K+2−τ(K+1)−2(β−1)K{1−τ(K+1)}]λ∗ = s −.
τ K [2(3 − β)K + 5]
|{z}
(+)

I If β is large enough (β ∗ < β) and trade costs are low enough (τ < τ ∗ ), thenλ∗ > s.
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Home market effect may be reversed

I In the interior equilibrium, we haveProposition 2 (Reverse HME)

If governments care about contributions heavily (β > β ∗ ) andtrade costs are low (τ < τ ∗ ),the small country obtains a more than proportionate share of firms.


24 / 31If τ < τ ∗ hold, we have d|T1∗ − T2∗ |/dβ > 0.

25 / 31If τ < τ ∗ hold, we have dλ1 /dβ > 0.

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Welfare implications
λo1 = argmax W ,W ≡ W1 + W2 .

Proposition 3

When the RHME prevails, the equilibrium share under the biased-gov.s is moresocially inefficient than that under the benevolent gov.s.

27 / 31Extensions: Asymmetric weight
I Consider asymmetric weights: β1 6= β2 .
I The government with a higher weight decreases its tax rate more.
I RHME still emerges.

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Conclusion
RemarkQ Empirical studies suggest the political weight β is small, which isinconsistent with the predictions.
→ Not every studies report small estimates. See Mitra et al. (2006).
→ Past empirical studies are based on trade policies, not on taxpolicies.
Summary
I Capital owners in both countries seek a fewer number of firms in thelarge market.
I The small country lowers its tax rate excessively because of lobbyingpressure by capital owners.
→ The reversal of the home market effect.
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Thank you for your attention!

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Small countries attract foreign capitalCountry size and (Inward FDI stock)/(GDP) of OECD countries in 2011.

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