DPRIETI Discussion Paper Series 24-E-024

Keep Your Friends Close and Your Enemies Closer: Network
externality and tax competition

OKOSHI, Hirofumi
Okayama University

MUKUNOKI, Hiroshi
Gakushuin University

The Research Institute of Economy, Trade and Industry

https://www.rieti.go.jp/en/

RIETI Discussion Paper Series 24-E-024
February 2024

Keep Your Friends Close and Your Enemies Closer: Network externality and tax competition *Hirofumi OKOSHI

Hiroshi MUKUNOKIOkayama University

Gakushuin University
Abstract

This study investigates the effects of network externality on the policy competition between two
countries regarding their attempts to attract a multinational enterprise (MNE). The two countries havedifferent numbers of consumers and endogenously set a tax/subsidy on the MNE. The larger country
has a local firm with a large market. Network externality makes the larger country with the local firm
more attractive to the MNE because the resulting larger supply amplifies the network size. The MNE's
location in the larger country can also benefit the local firm despite fiercer competition with the MNE
while also benefiting consumers in all countries. Fiscal competition increases the likelihood of a larger
country hosting the MNE when the network externality is large, but it promotes the MNE's location
in a small country when the network externality is small. A location change from a smaller to a larger
country, induced by fiscal competition, improves both countries' welfare or their joint welfare when
the network externality is significant.
Keywords: Network externality; Fiscal competition; Foreign direct investment; Digitalization
JEL classification: F13, F23, H25, L13

The RIETI Discussion Paper Series aims at widely disseminating research results in the form of professional
papers, with the goal of stimulating lively discussion. The views expressed in the papers are solely those of
the author(s), and neither represent those of the organization(s) to which the author(s) belong(s) nor the
Research Institute of Economy, Trade and Industry.

This study is conducted as a part of the project “Economic Policy Issues in the Global Economy” undertaken at the
Research Institute of Economy, Trade and Industry (RIETI). The draft of this paper was presented at a DP seminar of
the Research Institute of Economy, Trade and Industry (RIETI). We would like to thank Arpita Chatterjee, John Gilbert,
Andreas Haufler, Keisaku Higashida, Naoto Jinji, Satoshi Kasamatsu, Daiki Kishishita, Tidiane Ly, Mohammed
Mardan, Masayuki Morikawa, Gregory Ponthière, Martin Richardson, Dirk Schindler, Emmanuelle Taugourdeau,
Eiichi Tomiura, Halis Yildiz, Dennis De Widt, and the seminar participants at RIETI, Erasmus University Rotterdam,
Fukuoka University, Kyoto University, Musashi University, Toronto Metropolitan University, ATW 2023, IIPF 2023,
KVS New Paper Sessions and SOPE 2023. The usual disclaimer applies.
*

1

Introduction

Many factors influence firms’ foreign direct investments (FDIs), and digitalization of theworld economy has been one of the important changes affecting their FDI location choices.
According to the International Telecommunications Union, the share of internet users worldwide increased from 16% (1 billion users) in 2005 to 66% (5 billion users) in 2022, and almost
three-quarters of the world population in 2022 owned a mobile phone, which is the mostcommon gateway to the internet.1 Considerable attention has been paid to the impacts ofthe progress of digitalization, and its effect on firms’ location choices is one of them. For
instance, Baldwin and Freeman (2022) pointed out that the development of information andcommunication technology (ICT) enables firms to offshore some tasks across countries. Ko(2007) empirically showed that the internet plays a core role in attracting FDIs. Exploringfirms’ decisions under digitalization is critical to understand how ICT changes the shape ofglobal production.2
In addition to digitalization, there are other factors affecting firms’ location choices. Amongthem, fiscal policies such as the provision of tax incentives and that of subsidization are a main
tool for attracting FDI.3 Many countries have offered tax incentives to attract FDI in high-tech
products, such as semiconductors. As the Organisation for Economic Co-operation and Development (OECD) pointed out, however, one country’s change in fiscal policies can trigger
other countries to modify their policies, which may lead to “harmful tax competition”(OECD,1998). Fierce fiscal competition results in host countries collecting less tax revenue and thenproviding reduced public goods. It may also induce inefficient location choices among multinational enterprises (MNEs) and worsen host countries’ welfare. This concern about theharmful tax competition has been an important policy topic in the global economy. However, whether digitalization promotes or prevents harmful tax competition has been an open
question.
Among several features of digitalization, this study focuses on consumption network ex1 See https://www.itu.int/en/ITU-D/Statistics/Pages/stat/default.aspx and https://www.itu.int/
itu-d/reports/statistics/2022/11/24/ff22-mobile-phone-ownership/, accessed on July 7, 2023.
2 For instance, Chiappini and Gaglio (2024) empirically showed that sectoral digital intensity is associated withsectoral exports. Stallkamp et al. (2023) empirically showed that even if firms are able to distribute their products
remotely via digital channels such as apps, they may still establish a physical presence to sell those products byundertaking FDIs.
3 The host governments offer these policies to gain benefits from inward FDIs, such as transfer of superior
technology, higher wages, or greater consumer surpluses. See Navaretti and Venables (2020) for a survey ofbenefits from inward FDI.

1

ternality. Because users and suppliers are connected online, their behaviors affect others’
utilities and profits. For instance, consumers’ gains from purchasing network goods, such as
mobile phones, personal computers, and game consoles, increase as users of the same network good increase because they can interact more with other consumers (resulting in a direct
network effect). Moreover, consumers’ benefits also increase as online service providers become more willing to develop new services (resulting in an indirect network effect). Althoughconsumers are able to interact with other consumers and online service providers through theinternet, consumers still need to physically purchase network goods. Therefore, MNEs needto have a plant to produce network goods, and they are subject to fiscal competition for FDI.
However, how network externality affects fiscal competition has not been explored.
Some countries provide tax incentives to attract FDI from firms producing network goods.
For example, after Samsung announced its plan to establish a new mobile phone plant in 2007,
it was granted a large tax exemption from Vietnam, and the company established plants to
produce its smartphones in 2008.4 Similarly, Apple Inc. plans to produce laptop personal
computers in Vietnam, and it has also announced its smartphone production in India5 , which
introduced production-linked incentive scheme in 2020 to grant firms in several key sectors,
such as electronic manufacturing and ICT hardware, financial incentives based on their domestic investments, production, and sales.6 The chairman of India Cellular and Electronics
Association, Pankaj Mohindroo, stated “I just hope that India Inc. acts together so that we
provide the right space for them (Apple), because we lost Samsung completely to Vietnam.”
His statement indicates that there is fiscal competition between the two countries to attract
firms producing network goods.7
These trends in and anecdotes from the world economy raise important questions. How
does network externality influence MNEs’ location choices? How does it affect countries’
fiscal competition to attract MNEs? Does fiscal competition result in harmful tax competition?
4 See https://www.reuters.com/article/samsung-vietnam-idUSSEO33711720080321, accessed on June 5,2023. Vietnam also applies preferential tax rates or other tax exemptions to firms in certain sectors, including high-tech sectors that produce digital and IT products. See https://fia.mpi.gov.vn/en/Single/MenuID/
30ed8984-6d18-48b5-af2a-757cc6c65d90, accessed on February 19, 2023.
5 https://asia.nikkei.com/Spotlight/Supply-Chain/Apple-to-start-making-MacBooks-in-Vietnamby-mid-2023, accessed on February 19, 2023.
6 https://www.investindia.gov.in/production-linked-incentives-schemes-india, accessed on February 19, 2023. Some smartphone producers such as Samsung, Vivo, Xiaomi, and Oppo have set up manufacturing units in India. See https://www.kearney.com/technology/article/-/insights/are-companiesconsidering-india-for-electronics-vs-sticking-with-malaysia-vietnam-etc, accessed on April 26, 2023.
7 https://economictimes.indiatimes.com/industry/cons-products/electronics/we-must-notlose-apple-the-way-we-lost-samsung-to-vietnam-says-icea-chairman/articleshow/97251963.cms,
accessed on July 8, 2023.

2

To address these questions, we explore the fiscal competition between two countries in asituation where the consumption of goods generates network externality and there are local
competitors.8 Specifically, we consider a situation where two countries in the same region
have different market sizes, and there is a local incumbent firm in the larger country. Due tothe fixed costs of FDI, an MNE chooses to locate itself in either country in a region, where
they serve both markets. The local firm also sells its products to both markets, and thefirms’ exports incur trade costs. The consumption of goods generates network externality,and demand for goods increases as the total sales across the two countries increase. Given
this situation, we analyze the countries’ endogenous determinations of taxes/subsidies tomaximize their welfare.
Without network externality, the MNE faces a trade-off between the market size and competition effects. In other words, the MNE can sell goods without trade costs to many consumers (“friends”), but also faces fiercer competition with the local firm (“enemy”). If themarket size difference is small and trade costs are high, the MNE chooses a smaller country
to avoid the rival firm provided that the two countries have similar taxes/subsidies. The network externality provides additional benefits due to the MNE’s location in a large country.
Because a larger market size and competition with the local firm increase the product’s total
worldwide sales, being located in a large country with a local firm amplifies the network effect and benefits the MNE. Furthermore, such strong network effects due to being located in alarge country also benefit consumers in both countries and the local firm in the large country
because of the direct network effect and the expansion of demand. Therefore, the network
externality incentivizes the MNE “to keep its friends close and its enemies closer”comparedwith a case without the network externality, where the MNE’s choice is between “keeping its
friends close or keeping its enemies far.”Our model also shows that network externality can change the winner of fiscal competition among countries. Without network externality, as Bjorvatn and Eckel (2006) pointed
out, the local firm’s loss of profit makes the larger country less willing to welcome the MNE,
and as a result of the fiscal competition, a small country can host the MNE. Given the small
network effect, the large country will be less aggressive in fiscal competition because of thelocal firm’s presence, whereas a small country is more aggressive to increase its consumer
8 In India, MNEs producing smartphones compete with local smartphone producers, such as Micromax Mobile, Lava International, and Karbonn Mobiles.

3

surplus. Consequently, the fiscal competition changes the MNE’s location from a large country to a small country, which is the same result as a case without network externality. Whenthe network externality is large, positive network effects on consumers in both countries andon local firms are higher when the MNE is located in a larger country. Therefore, the larger
country becomes more aggressive, and the smaller country becomes less aggressive in thefiscal competition. Consequently, in contrast to the previous two cases, the larger country ismore likely to host the MNE when the network externality is large.9
We also investigate whether fiscal competition is harmful in terms of welfare. In line withthe previous papers, fiscal competition always leads to MNEs’ efficient location and attains
the largest total welfare. This is because the country that benefits the most from an MNE’s
location offers the most generous fiscal policy and wins the fiscal competition. Since thegovernments’ taxes/subsidies are purely transferred to MNEs, fiscal competition maximizes
total welfare. The efficient location of MNEs that fiscal competition accomplishes, however,does not necessarily benefit the countries engaged in the competition. When the winningcountry offers MNE an investment subsidy, the MNE captures some of the efficiency gains,
and the fiscal competition may hurt the competing countries. Our model predicts that fiscal
competition benefits the winning country when the competition changes the location of the
MNE or when the equilibrium fiscal policy is a tax.
Even if the fiscal competition changes the location of an MNE, the country that loses the
fiscal competition and the MNE may both still benefit from the relocation. If the losing country is the large country, the relocation occurs under small network externality and large trade
costs. In this case, the local firm in the large country benefits from the relocation, and thiseffect dominates the consumer loss. If the losing country is the small country, the relocation
occurs when the network externality is large. If the network externality is sufficiently large,
the relocation benefits the consumers in the small country due to the network effect. Additionally, even if the losing country suffers welfare loss, the fiscal competition could improve
the joint welfare of the two countries in the region.
These results suggest that “harmful tax competition” is less likely to occur when network
externality is sufficiently large, and the location of MNEs in the larger and more competitive
countries not only benefits consumers in those countries but also benefits domestic firms in
9 Amerighi and De Feo (2017) also showed a case where fiscal competition changes an MNE’s location froma smaller to a larger country, despite a local firm’s presence in the larger country. In their study, the distinction
between private and public firms is the key. In contrast, this study focuses on the role of network externality.

4

those countries and consumers in other countries. The promotion of digitalization is important not only for facilitating online transactions but also for weakening the harmful effects oftax competition on attracting MNEs.

1.1

Related LiteratureThis study relates to two strands of the literature. First, many studies have investigated fiscal
competition for FDI. One seminal study was conducted by Haufler and Wooton (1999), whodemonstrated that the market size difference is an important determinant of the location
choice of a monopolistic MNE. They showed that a larger country wins the tax competition.
Some other studies have added new elements to the market size difference. Barros and Cabral(2000) considered an unemployment problem in a smaller country and highlighted a casewhere the smaller country wins the tax competition. Bjorvatn and Eckel (2006) demonstrated
that competition with other firms also affects tax competition winners, and a smaller country
without local firms is more likely to win the tax competition.
Some recent research has extended these seminal studies by including new elements.
Amerighi and De Feo (2017) considered a situation where the local firm is a public firm thatmaximizes domestic welfare. They demonstrated that a larger country with a public firmalways benefits from attracting FDI. Ma and Wooton (2020) analyzed the role of product differentiation and demonstrated that fiscal competition only has a redistribution effect and does
not affect new entrants’ location choices. Ferrett and Gravino (2021) considered technologicalspillover from an MNE to a local firm and demonstrated that MNEs prefer away from local
firms to limit technology spillover, but fiscal competition induces MNEs to locate themselvesclose to local firms, improving world welfare. Our study is distinct in the following ways:
It examines the effects of network externality and provides new policy implications for fiscal
competition amid the digitalization of the economy.10
Second, this study contributes to the literature on international trade and network externality. For instance, Klimenko and Saggi (2007) investigated entrant firms’ choice between
greenfield FDI and mergers and acquisitions (M&A) in the presence of network externality and demonstrated that stronger network externality reinforces M&A because it increases
10 These papers considered a single MNE, but some papers, such as Ferrett and Wooton (2010), Haufler andWooton (2010) and Ferrett and Wooton (2021), considered tax competition when there are more than two MNEs.
Other studies considered fiscal competition among more than three countries/regions, as in Haufler and Wooton(2006), Darby et al. (2014), and Janeba and Schulz (2020).

5monopoly profit and lowers the acquisition price. Kao and Mukunoki (2021) investigated theeffects of permitting parallel imports of platform products that generate two-way network externality and demonstrated that parallel imports benefit platform producers and consumers
in all countries when the network externality is large. Klimenko and Qu (2023) compareda foreign platform firm’s entry through greenfield FDI and the acquisition of the incumbent
platform and demonstrated that the degrees of technology transfer, network externality, andproduct differentiation determine the two modes’ private and social desirability. However,none of these studies investigated the impact of network externality on tax competition.
The remainder of this paper is organized as follows. Section 2 presents the model andderives the market outcomes. Section 3 discusses MNEs’ location choices and investigates
how fiscal competition changes the equilibrium location. Section 4 explores the welfare effectsof fiscal competition to identify whether fiscal competition is harmful. Section 5 further
discusses the model and the results. Section 6 concludes.

2

Model

This section provides a formal model and explores the outcomes of the product market competition. Section 2.1 sets up an international fiscal competition model. Section 2.2 derives
the equilibrium in the product markets and examines how MNE location and the degree of
network externality affects market outcomes.

2.1

Setup

We consider a region comprising two countries (countries A and B) and two industries. The
industry X is under imperfect competition, which is this study’s main focus. The otherindustry is under perfect competition and produces numéraire goods.
An MNE, firm M, has headquarters in a foreign country outside the two countries. Firm
M must establish a plant in these countries to sell its products in both countries, possibly
because of the high trade costs associated with exporting from outside the region. We assume
that firm M establishes its plant in only one country in the region because of the high fixed
costs associated with plant establishment.11 The two countries are heterogeneous in two
11 The same assumption has been employed in the literature on fiscal competition, such as in Bjorvatn and
Eckel (2006).

6

Figure 1: Model
respects. First, country A’s population is n times larger than country B’s. Let ni be thepopulation of country i. For simplicity, we normalize the market size in the smaller country
B to unity, and hence, n A = n > 1 = n B holds. Second, a local incumbent firm exists, firm L
in the larger country, A. Figure 1 describes the model’s structure.

2.1.1

Consumers

Each individual’s utility from consuming network goods and numéraire goods are additively
separable. Each consumer decides to buy one unit of the network good. Each consumer’s net
utility from consuming the network good in country i is given by:

ui = θ + νY − pi ,(1)

where pi is the price of network goods in country i, and θ is consumers’ willingness topay for the network good. Consumers have different θ, and this is uniformly distributedon θ ∈ (−∞, α] in both countries. We consider consumption network externality: Y is the
expected network size, which is equal to the total consumption of network goods in the twocountries. Each consumer’s utility increases as Y increases. The parameter ν captures thedegree of network externality. There is no externality when ν = 0.

7

Consumers in country i buy network goods if and only if ui ≥ 0 holds. Let θ i be thewillingness to pay for the network good, such that ui = 0 holds: θ i = pi − νY. Then, theRαaggregate demand of the network good becomes ni θ 1dθ = ni (α − θ i ), and we assume thatithe two markets are segmented such that the market clears in each market. The marketclearing condition requires ni (α − θ i ) = X Mi + X Li , where X Mi is firm M’s supply and X Li isthe local firm’s supply of the network good in country i. By combining this equation withui ≥ 0, we obtain the aggregate inverse demand function in country i as:
pi = α + νY −X Mi + X Li
.
ni

(2)

The corresponding consumer surplus in country i becomes:

CSi = niZ α(θ + νY − pi )dθ =

θi

2.1.2

( X Mi + X Li )2
.
2ni

(3)

Firms

Firms M and L produce a homogeneous network good and engage in Cournot competition.
Both firms produce network goods using the same production technology, and their marginal
production costs are given by c. Both firms supply their products in both markets, implyingthat they are both exporters. They incur a per unit trade cost τ.
Henceforth, let the superscript letter indicate the country where firm M is located. Given
that firm M is in country j, firm L’s profit is given by
j

j

j

j

j

Π L = ( p A − c) X LA + ( p B − c − τ ) X LB

(4)

where j ∈ { A, B}. Firm M’s profit is given by
j

j

j

j

j

Π M = ( p j − c) X Mj + ( pk − c − τ ) X Mk − t j ,(5)where k ̸= j and ti represents a fiscal policy set by country j. We will explain ti below.
2.1.3

Governments

Because of the heterogeneity between the two countries and the presence of trade costs, firm
M’s location affects the welfare of countries A and B. Here, we consider a fiscal policy that8

affects firm M’s investment: Government i imposes lump-sum investment tax ti on firm M’sinvestment in country i. If ti < 0, then the government offers an investment subsidy.12
Country A’s welfare comprises the consumer surplus, firm L’s profit, and the possible tax
revenues/subsidy payments. Country B’s welfare comprises the consumer surplus and tax
revenues/subsidy payments. Given firm M’s location in country j, we have
j

j

j

j

WA = CS A + Π L + λ A t A ,

and

j

j

j

WB = CSB + λ B t B ,

j

(6)
j

where λi (i = { A, B}) is a binary parameter that takes unity if country i hosts firm M (λi = 1
where i = j) and zero otherwise.

2.1.4

Timing of the gameWe solve the following four-stage game. At Stage 1, the two countries simultaneously determine their fiscal policies ti to maximize their own welfare. In Stage 2, firm M chooses its
subsidiary production location. At Stage 3, consumers form their network size expectations.
Following Katz and Shapiro (1985) and Wu et al. (2022), we do not examine how expectations
are formed and rather suppose that consumers’ expectation would be fulfilled in prpoportion
to the actual network size (i.e., total consumption of the network good) in equilibrium. At
Stage 4, firms engage in a Cournot competition in each market.

2.2

Product Market Competition and Network Externality

This subsection derives the equilibrium of subgames at Stage 3 and Stage 4, given firm M’s
location and the govenrments’ fiscal policies. It also examines how firm M’s location and thepresence of the network externality affects consumers in each country as well as the local firmin Country A. For notational brevity, we use a = α − c hereafter.

2.2.1

Market Outcomes

At Stage 4, given firm M’s location in country j, firms M and L set their supplies in eachmarket to maximize their respective profits. Although each firm’s supply affects total consumption and consumers’ willingness to pay through the network effect, firms do not control
12 In the case of subsidization, ti < 0, one may wonder how the governments finance the subsidy. Although we
do not explicitly incorporate the source of finance, following Haufler and Wooton (1999), introducing a head tax
from consumers is an option.

9

for the expected network size and take Y as given.13 At Stage 3, consumers predict the size of
j

j

j

j

the network, and those expectations coincide with the actual size Y j = X Mj + X Lj + X Mk + X Lk .
Combining this equation with the first-order conditions of profit maximization at Stage 4, theequilibrium output when firm M is located in country A becomesn2{(1 + n) a − τ }νAAbb
X MA = X LA =a+,3
3 − 2(1 + n ) ν


2
{(
1
+
n
)
a
−
τ
}
ν
1
A
A
b MB = X
b LB =a−τ+.
X
3
3 − 2(1 + n ) ν

(7)
(8)

Throughout the analysis, we focus on the case where both firms supply finite amounts of
their products in both markets. This restricts the range of ν and τ to 0 ≤ ν < 2(13+n) ≡ νmax
and 0 ≤ τ < 2−(1a+n)ν ≡ τ max , respectively. Therefore, 3 − 2(1 + n)ν > 0 in these equations.
The second terms in parentheses in these equations represent the network effect. When firm
M is located in country B, the outputs are




n
(1 + n)(2a − τ )νn
(1 + n)(2a − τ )νB
Bbb
X MA =
a − 2τ +, X LA =a+τ+3
3 − 2(1 + n ) ν3
3 − 2(1 + n ) ν
B
B
b
X
X
B
B
b LB
b MB
= MA .
X= LA , X
n
n

(9)
(10)

By substituting these outputs into the profit function, we obtain the equilibrium profits
j

j

b .
b and Πwhen firm M is in country j, denoted by Π
L
M
2.2.2

Effects of MNE location on consumers and the local firm

Before exploring firm M’s location choices and the two governments’ fiscal competition, we
examine how firm M’s location affects consumers in each country and the local firm’s profit.
Given that the network size affects consumers’ willingness to pay, let us first compare how
firm M’s location affects the equilibrium network size, which coincides with the total equilibrium sales of a network good in the region. We can confirm that the equilibrium networkb j is always larger when firm M is located in country A:
size YbA − YbB =Y( n − 1) τ
> 0.
3 − 2(1 + n ) ν(11)

13 As mentioned in the Introduction, the network externality implicitly represents both the direct and indirect

network effects. It should be difficult for firms to accurately predict how their individual supplies will affect the
number and the quality of online services.

10This is because, by locating in country A, firm M supplies free of trade cost in a country
with a larger market and a local firm. Consequently, the equilibrium sales are always larger
than in the case where firm M is located in country B and bears the trade cost of supplying
in country A. The network size difference increases as the degree of network externality ν
grows because a larger ν magnifies the network effect on consumers’ willingness to pay andfurther incentivizes firms to supply network goods.
The difference in the equilibrium network sizes affects governments’ incentive to attract
firm M by changing the effects of the MNE’s location on consumer surplus and the local firm’s
profits. By Eq.(3), each country’s consumer surplus improves if total sales in the country
increase. In country A, we have
A
A
B
B
b MA
b LA
b MA
b LA
(X
+X
) − (X+X)=nτ
2nτν(n − 1)n(3 − 4ν)τ=+> 0.
3{3 − 2(1 + n ) ν }33{3 − 2(1 + n ) ν }(12)

ν < νmax ensures that the denominator is positive. The equation’s second term represents the
network effect and is positive, implying that network externality magnifies the consumers’
gains from hosting the MNE and thereby strengthens government A’s desire to attract FDI.
In country B, we have
B
B
A
A
b MB
b LB
b MB
b LB
(X
+X
) − (X+X)=(3 − 4nν)τ
τ
2(n − 1)τν
= −⪌0
3{3 − 2(1 + n ) ν }3 3{3 − (1 + n ) ν }3⇐⇒ ν ⪋ νCS ≡
.
4n

(13)

This implies that the total sales in country B are larger when firm M locates in country A
if the degree of the network externality and country A’s market size is sufficiently large tosatisfy νCS (∈ (0, νmax )). In this case, consumers in country B will oppose attracting FDI.
Without network externality, hosting the MNE always increases consumer surplus incountry B, because the MNE supplies goods without trade costs. However, the overall network size is larger when firm M locates in country A, where the market size is larger and themarket competition is more intense. If the degree of network externality is sufficiently large,
the latter effect dominates the former, and consumers in country B will prefer not to attract
Firm M domestically. We have the following proposition:
Proposition 1. The consumer surplus in country A is greater when firm M is located in country
A rather than country B. There exists a threshold level of network externality, νCS , such that the11consumer surplus in country B is greater when firm M is located in country A if ν > νCS . The
consumer surplus in country B is greater when firm M is located in country B otherwise.
The network effect also changes the effects of hosting the MNE on the local firm. Becauseof the network effect, firm L may benefit from having firm M in the same country. On the
one hand, having firm M in the same country intensifies market competition and harms firm
L. On the other hand, having a rival in a larger market increases the overall network size,
increasing consumers’ willingness to pay in both countries and thus increasing both firms’
profits. If the latter effect dominates the former effect, the local firm’s profit will be larger
given the inward FDI. Specifically, we have(n − 1)Γ L τνb LA − Πb BL = − {2a(n − 1) + (n + 3)τ }τ −,
Π99{3 − 2(1 + n ) ν }2(14)

where Γ L ≡ 6{(n + 1) a − nτ } − (n + 1){8(n + 1) a − (5n + 3)τ }ν. With a sufficiently large ν,Γ L is negative, and the second term becomes positive. If the positive second term dominates
the (always negative) first term, firm M’s location in country A will benefit firm L. Thereexists a threshold of ν, ν L ∈ (0, νmax ), such that Π LA > Π BL holds for ν L < ν < νmax , andΠ LA ≤ Π BL holds otherwise.14 The following proposition summarizes the results.
Proposition 2. There exists a threshold level of network externality, ν L , such that the local firm’s
profit in country A is greater when firm M locates in country A rather than in country B if ν > ν L .
The local firm’s profit is greater when firm M is located in country B otherwise
Propositions 1 and 2 suggest the important role of network externality in fiscal competition. Traditionally, attracting FDI is beneficial for consumers but harmful for local firms.
However, our results suggest that having MNE in a large country rather than in a small country benefits the local firms in the larger country and the consumers in all countries if thedegree of network externality is sufficiently large. Therefore, network externality criticallyaffects governments’ incentive to attract FDI, which we will discuss in Section 3.2.
*****
14 The order of the two thresholds, νCS and ν L , depends on parameter values.

If the market size difference
and trade costs are sufficiently large, νCS < ν L holds, and firm M’s location in country A benefits consumers incountry B but hurts the local firm in country A when νCS < ν < ν L . Otherwise, ν L < νCS holds and firm M’s
location in country A benefits the local firm in country A but decreases consumer surplus in country B when
ν L < ν < νCS .

12

3

Location Choice and Fiscal Competition

This section explores which country the MNE chooses for its production location and how
the two countries’ fiscal competition affects the equilibrium location. As a benchmark, we
first examine firm M’s choices without policy competition; that is, when the two countries
employ common fiscal policies. We then examine MNE’s location choice with policy competition. Comparing these two cases allows us to determine how policy competition changes
equilibrium location. We demonstrate that the effects of policy competition critically dependon the degree of network externality.

3.1

Exogenous policy

To examine the impact of fiscal competition on firm M’s location, we first consider firm M’s
location choice without government fiscal competition. Suppose that t A = t B = t holds, suchthat the investment taxes/subsidies do not affect firm M’s location choice between the twocountries. By comparing firm M’s profit when located in country A with its profit when it islocated in country B, we haveA(Π M
− Π BM )t A =t B =t=4{(n − 1) a − nτ }τ
9
{z
}
|

+/−: Market size/Competition effect+(n − 1)Γ M τν≡ Ω,
9{3 − 2(1 + n ) ν }2
|
{z
}

(15)

+: Network effectwhere Γ M ≡ 6{5 (n + 1) a − τ (3 + 2n)} − (n + 1) {16 (n + 1) a − (9 + 7n) τ }ν > 0 due to ν <νmax . The first term captures the difference between the sum of the market size and thecompetition effect between the two markets, which can be positive or negative. Firm M facesa trade-off between larger and fiercer market competition when locating country A. It is
positive if n is sufficiently large and τ is sufficiently small. This trade-off is Bjorvatn and
Eckel (2006)’s main point.
In addition to the market size and the competition effect, the second term captures the
positive network effect. As Eq.(11) suggests, the network size is larger when firm M is locatedin country A. A greater network effect increases consumers’ willingness to pay and enhances
the demand in both countries, which increases firm M’s profits.
The sum of these two terms, Ω, represents country A’s fundamental location advantage
over country B. Without policy competition between the two countries, the sign of Ω determines firm M’s location. From Eq.(15), we derive the cutoff level of τ under no fiscal

13

competition, τ n f c , below which firm M will prefer to locate in country A and above which it
will prefer to be located in B. Specifically, we haveΩ ⋛ 0 ⇐⇒ τ ⪋ τ n f c ≡18 (n − 1) {2 − (n + 1) ν} a36n − {6(3 + 7n + 6n2 ) − (n + 1)(9 + 14n + 9n2 )ν}ν(16)

Since the network effect always enhances county A’s attractiveness as a production place, anincrease in the degree of network externality ν will induce firm M to locate in country A andwill also increase τ̄ n f c . The following lemma summarizes the MNE location choice without
policy competition.
Lemma 1. Suppose there is no fiscal competition to attract FDI. If τ ≤ τ n f c holds, firm M chooses thelarger country, where local firms are also located, as its production location. Otherwise, firm M selects
the smaller country without local firms. Firm M is more likely to choose a larger country as network
externality strengthens.
Figure 2 shows a numerical example of firm M’s location choice in the ν-τ plane, where
the solid upward curve represents τ n f c .15 Given the small network externality, firm M chooses
country B if τ is high but selects country A if it is low. As the network externality increases,
country A becomes more likely to host firm M. When ν is sufficiently high, τ̄ n f c > τ max holds,
and country A always hosts firm M. This figure also depicts νCS and ν L . If ν is sufficiently
high so as to exceed these thresholds, firm M’s location in country A rather benefits the local
firm in country A and consumers in country B.

3.2

Endogenous policy

We now turn to the case where each government sets respective fiscal policies, ti . At StageA − ΠB = Ω −2, firm M chooses its location to maximize its profit given t A and t B . As Π M
M(t A − t B ), the fiscal competition can change firm M’s location. Specifically, if Ω > 0 andt B < t A − Ω hold, country B will attract firm A, which, without fiscal competition, would
have chosen country A. Similarly, if Ω < 0 and t A < t B + Ω hold, country A attracts firm Mthat would choose country B without fiscal competition.
At Stage 1, governments design their fiscal policies to maximize their own welfare. As thegovernments compete for the MNE outside the two countries, and firm M will only establish
one plant, fiscal competition becomes an auction between the two countries. Before deriving
15 The parameters are set to a = 1 and n = 1.1. With these parameter values, νmax = 5/7 ≈ 0.71429.

14Figure 2: MNE location choice without policy competition
the equilibrium, we first consider the two countries’ most generous fiscal policies, ti , below
which country i has no intention to attract firm M.
By comparing Country A’s welfare with and without Firm M’s presence, t A is given by
WAA ≥ WAB ⇐⇒ t A ≥ t A ≡ −|{4a − 3(2 + n)τ }τ
ξ A τν
−
18
9
{
3
−
2
(1 + n ) ν }2
{z
}|
{z
}
+/−

(17)

−



where ξ A ≡ 6{ 1 + 3n2 a − 2τn} − {8(1 + n)2 a − 3 + 15n + n2 − 3n3 τ }ν > 0 due to ν <νmax . The level of t A is divided into two components. The first term captures the effects
of hosting firm M, which exists without network externality. In the absence of network
externality, hosting the MNE increases consumer surplus, but simultaneously reduces firm
L’s profit. Therefore, the sign of the first term can be either positive or negative. If the market
size effect dominates the competition effect, the first term is negative, and country A is willingto offer an investment subsidy t A < 0 even without the network effect.
The second term reflects the network-externality-enhancing effect of hosting the MNE.
Because hosting firm M saves trade costs and increases national supply, country A becomes
more eager to attract firm M domestically in the presence of network externality. Additionally,
the overall network size is always larger when country A hosts firm M. Owing to these effects,
15

the second term is negative, and the network externality reduces the lowest t A that country
A is willing to offer.
For country B, t B is calculated as
WBB ≥ WBA ⇐⇒ t B ≥ t B ≡ −|2ντξ Bτ (4a − 3τ )−18
(1 + n ) ν }2{z
} | 9{3 − 2{z
}
−

(18)

+/−


where ξ B ≡ 3{4a − τ (3 − n)} − ν{4(n + 1)2 a − 3 + 6n − n2 τ }. The first term captures
consumer gains from hosting firm M without network externality, which reduces the lowestt B that country B can offer. The second term captures the network effect, and its sign depends
on the degree of network externality. On the one hand, the network externality increases the
MNE’s supply and country B’s consumer gains from hosting firm M domestically by saving
trade costs. This effect reduces t B . However, the overall network size decreases if country B is
the host, diminishing the network effect. If ν is small, the former effect dominates the latter,and the second term is negative. However, if v is large, then the latter effect dominates theformer, and the second term becomes positive. As t B = 0 at ν = νCS and t B > 0 for v > vCS ,country B offers an investment tax whenever hosting firm M reduces consumer surplus.
Given the most generous fiscal policies, we can identify the conditions under which a
country would succeed in attracting firm M. Note that the most generous fiscal policies
determine the winner of the fiscal competition, but the winning country’s equilibrium fiscaljpolicy differs from t j . See Section 4.1 for details. By substituting t j for Π M , we obtainAΠM(t A ) ⪌ Π BM (t B ) ⇐⇒ τ ⪋ τ f c ≡72(n − 1) a.
9(3 + 11n) − 4ν{3 − (1 + n)ν}(9 + 10n + 9n2 )(19)Country A attracts firm M when trade cost is less than τ̄ f c , but country B attracts firm M
when the trade cost is greater than τ f c . As in the case without fiscal competition, firm M
prefers to be located in the smaller country, B, when τ is large because of the absence of local
firms coupled with the protection country B offers Firm M from high trade costs. When τis small, firm M will choose country A because a larger market size is more important than
avoiding fiercer competition with local firms. τ f c is increasing in ν, implying that stronger
network externality increases country A’s attractiveness because the overall network size islarger if firm M is located there. Subsequently, we have the following lemma.
Lemma 2. In the presence of fiscal competition, firm M chooses a larger country with a local firm if
16

Figure 3: Location choice with policy competitionτ ≤ τ f c holds. Otherwise, firm M chooses a smaller country without local firms. Firm M is more
likely to choose a larger country as the network externality strengthens.
Figure 3 shows a numerical example of firm M’s location choice with endogenous taxes
or subsidies, where the solid upward curve represents τ f c .16 The dotted line indicates thethreshold level without policy competition, τ n f c . As before, network externality increases thelikelihood of country A hosting firm M, and country A always hosts firm M if ν is sufficiently
high. Figure 3 also indicates that whether fiscal competition induces firm M’s relocation tocountry A or B depends on the degree of network externality. Subsequently, we have thefollowing lemma (see Appendix A.1 for proof).
Lemma 3. There exists a network externality cut-off level, νe, such that fiscal competition decreases
the threshold level of trade costs, below which firm M locates in a larger country for ν ∈ [0, νe), andincreases the threshold level for ν ∈ (νe, νmax ).
When the network externality is insignificant, country A cares more about the local firm’s
profit loss than consumer gains. However, consumers’ gains from hosting an MNE are large
in country B. Therefore, country A is less aggressive, whereas country B is more aggressive
16 The same parameters are set as those in Figure 2.

17

in attracting firm M. Consequently, the fiscal competition expands the range of τ, in whichfirm M chooses country B. By contrast, when the network externality is significant, hosting
firm M in country A hurts the local firm less (or even benefits it), while benefiting consumers
more. Meanwhile, consumers’ gains from hosting firm M are relatively small in country B.
This is because firm M’s location in country A expands the overall network size, thereby
enhancing demand in all countries. Therefore, the fiscal competition expands the range of
τ, in which firm M chooses country A.17 The following proposition describes how fiscal
competition changes the equilibrium location.
Proposition 3. Fiscal competition changes the MNE’s location from a larger country to a smaller
country if ν ∈ [0, νe) and τ̄ f c < τ ≤ min[τ n f c , τ max ] hold. It changes the MNE’s location from asmaller country to a larger country if ν ∈ (νe, νmax ) and τ̄ n f c < τ ≤ min[τ f c , τ max ] hold. Otherwise,
fiscal competition does not affect the equilibrium location.
The results provide new insight into the link between network externality and locations of
MNEs. Usually, countries with large markets have a larger number of local firms that generate
trade-offs between consumer gains and local firms’ profit losses when hosting MNEs. Small
countries are eager to host MNEs because they care more about consumer gains and are
more likely to win the fiscal competition. Bjorvatn and Eckel (2006) have pointed out thisresult. Network externality affects these countries’ eagerness to attract MNEs. When the
degree of network externality is high, larger countries are more likely to host MNEs despite
the presence of local rival firms. This implies that countries with larger markets, such as
the United States and India, tend to successfully attract MNEs in industries where a strong
network externality prevails. By contrast, smaller countries are more likely to attract MNEs
in industries that do not generate much network externality. A country’s fiscal competition
amplifies the magnitude of the network effects on MNEs’ location choices.

4

Welfare analysis

We have shown that the effects of fiscal competition on an MNE’s location depend on the
degree of network externality. This section explores the welfare effects of fiscal competition
to determine whether fiscal competition is harmful.
17 In the numerical example illustrated in Figure 3, we have νe = (24 275 − 518√1775041)/43 246 ≈ 0.40729.

If we consider the total welfare, which is the sum of the welfare of countries A and B
and the MNE’s profits, the equilibrium location with fiscal competition is always efficient andalways achieves the largest total welfare. Since the country that benefits more from hosting the
MNE wins the policy competition by offering a more generous fiscal policy, the equilibrium
location with fiscal competition always generates efficient outcomes (See Appendix A.2 for a
detailed calculation).18 This indicates that, irrespective of the direction of the MNE’s location
change, firm M’s location changes induced by fiscal competition always improve the total
welfare. Therefore, fiscal competition cannot be harmful in terms of total welfare.
An efficient outcome of fiscal competition does not necessarily mean that countries in theregion will benefit from it. To simplify the analysis, we set t A = t B = t = 0 such that thetwo host countries set no investment tax/subsidy without fiscal competition.19 If the equilibrium fiscal policy is an investment subsidy, some of the host country’s gains are transferredto the MNE. Therefore, there is a case where fiscal competition worsens the winning country’s welfare. If fiscal competition causes the relocation of the MNE, the fiscal competition
loser’s welfare may be reduced. Therefore, fiscal competition can be harmful to the countries
engaging in it.

4.1

The equilibrium fiscal policy

We need to derive the equilibrium fiscal policy to derive the conditions under which fiscal
competition improves the competing countries’ welfare. Note that countries’ most generous
fiscal policies determine which country wins the policy competition, but these differ from theequilibrium fiscal policies.
A ( t ) > Π B ( t ) holds and country A wins fiscal competition to attract firm M,
When Π MA
M B
A ( t ∗ ) = Π B ( t ).
country B sets t B and country A sets t∗A in equilibrium such that it satisfies Π M
M B
AA ( t ) holds, country A sets t but country B sets t∗ such that it
Similarly, when Π BM (t B ) > Π M
AA
B
A (t ). We havesatisfies Π BM (t∗B ) = Π M
At∗A = t B + Ω,andt∗B = t A − Ω.

(20)

18 This result is consistent with those of previous studies such as Barros and Cabral (2000), Fumagalli (2003),
Bjorvatn and Eckel (2006), and Ferrett and Gravino (2021).
19 The effect of fiscal competition on each country’s welfare depends on the level of the two countries’ uniform
tax/subsidy without competition, t A = t B = t. Fiscal competition is more likely to worsen the welfare ofcompeting countries in the region as t becomes higher.

19Figure 4: Equilibrium fiscal policies
As explained in Section 3.1, Ω is country A’s fundamental location advantage over country B.
The winning country’s equilibrium fiscal policy tends to be a tax when the losing governmentis less eager to attract firm M and firm M’s incentive to locate in the winning country is strong.
Figure 4 presents a numerical example of equilibrium fiscal policies.20 τ tA is the thresholdlevel of τ, below which t∗A > 0 holds. The figure also shows the threshold level τ tB , above
which t∗B > 0 holds.21 The large country (country A) wins the competition and sets a positive
investment tax if the network externality is sufficiently large. Strong network externality
discourages country B from attracting firm M because the MNE’s location in country A
would hurt consumers in country B less or may even benefit them. The strong network
externality also increases country A’s fundamental location advantage. The small country(country B) wins the fiscal competition with a positive investment tax when the network
externality is weak and trade costs are high. This is because higher trade costs decrease thelarger country’s location advantage and increase the lowest tax (largest subsidy) the larger
country is willing to offer.
In the following subsections, we examine how fiscal competition changes the joint welfare
20 The same parameters are set as those in Figure 2.
21 With a = 1 and n = 1.1, τ tA = 60(377ν − 240) / (64 429ν2 − 81 360ν + 26 100) and τ tB = 1200(9 −11ν) 69 709ν2 − 105 870ν + 40 725 .

20

of the two countries in the region and how it changes each country’s welfare in the region.

4.2

The countries’ joint welfare in the region

Let us consider the joint welfare of the countries in the region, which we will hereafter referto as the regional welfare. The regional welfare is defined as the sum of two countries’
individual welfare. If fiscal competition reduces the regional welfare, it should be regarded
as harmful tax competition in the sense that any transfers between the countries cannot leadto improved welfare in both countries.
Fiscal competition improves the regional welfare if the winning country offers an investment tax. Since fiscal competition always achieves the highest total welfare, it improves theregional welfare if the winning country acquires a portion of the MNE’s profits via the collection of an investment tax. Conversely, if the winning country offers an investment subsidy
and fiscal competition does not change the MNE’s location, the fiscal competition worsens
the regional welfare by failing to generate efficiency gains.
If fiscal competition changes the MNE’s location, the region reaps efficiency gains from
the MNE’s relocation. In this case, fiscal competition can improve the regional welfare even
if the winning country offers an investment subsidy. First, suppose a case of weak network
externality, ν ∈ (0, νe) and τ̄ f c < τ ≤ min[τ n f c , τ max ], where fiscal competition changes the
MNE’s location from country A to B. Since we assume t A = 0 without fiscal competition, we
have
WAB + WBB ⪌ WAA

t A =0JW≡⇐⇒ τ ⪌ τ AB

+ WBA

12{3 (2n − 1) − (4n + 3) ν + 3n2 ν} a
. (21)
9 (14n + 9) − 12 (12n2 + 17n + 15) ν + 2 (27n3 + 61n2 + 53n + 27) ν2

Hence, the fiscal competition responsible for inducing the MNE’s relocation from Country A
JW
to B increases the regional welfare if τ > τ AB.

Second, suppose a case of strong network externality, ν ∈ (νe, νmax ) and τ̄ n f c < τ ≤ τ f c ,where fiscal competition changes the MNE’s location from country B to A. Since we assume21

Figure 5: Policy-induced MNE location changes and joint welfare (n = 1.1)
t B = 0 without fiscal competition, we have
WAA + WBA ⪌ WAB + WBBJW≡⇐⇒ τ ⪋ τ BA

t B =012{3 (2n − 3) + 4nν} a99n − 36 (3n2 + 2n + 3) ν + 4 (9n3 + 15n2 + 19n + 9) ν2

.

(22)

Unlike the previous relocation pattern, the fiscal competition responsible for inducing the
MNE’s location changes from country B to A increases the regional welfare if the trade costs
JW
are small τ < τ BA.

Figure 5 presents a numerical example of how the fiscal competition-induced MNE location change affects the regional welfare, when the two countries set no tax/subsidy in theabsence of policy competition. It employs the same parameters as the previous figures, whereJW
the market size difference is not so large (n = 1.1). In this case, τ AB
is always larger thanτ n f c , and the policy-induced location change of the MNE from country B to A necessarily
JW
worsens the regional welfare.22 By contrast, τ BA
is larger than τ n f c when the extent of the

network externality is sufficiently large. Therefore, the policy-induced MNE location change
JW
from Country B to A improves the regional welfare if τ̄ n f c < τ < τ BA
holds. As the extent ofJW
the network externality increases, τ BA
becomes larger. This is because a larger network exter22 Appendix A.4 provides another numerical example and shows the case where τ JW < τ̄ n f c holds.
BA

22

nality enhances both the two countries’ efficiency gains and the MNE’s gains from choosing
a larger country.
As discussed, if fiscal competition does not change the MNE’s location, the fiscal competition never affects firms’ supplies, and thus, a tax (subsidy) always improves (hurts) regional
welfare. If τ < min[τ f c , τ tA ] holds, country A wins the fiscal competition with a positive
investment tax, and the regional welfare improves because there is no change in country B’s
welfare. If max[τ f c , τ tB ] < τ < τ max holds, country B wins the fiscal competition with a positive investment tax, and the regional welfare improves. Proposition 4 summarizes the effectsof fiscal competition on regional welfare.
Proposition 4. Suppose there are no investment taxes or subsidies without fiscal competition. Fiscal
competition improves the regional welfare if an investment tax is imposed on the MNE. If an investment
subsidy is imposed, fiscal competition improves the regional welfare if the subsidy leads to the MNE’s
JW
JWor τ < τ BA
holds. Otherwise, fiscal competition worsens regional
relocation, and either τ > τ AB

welfare.
These results suggest that whether we observe “harmful tax competition” among (potential) host countries depends not only on the market size difference and the trade costs but
also on the extent of the network externality. If the network externality is significant enough,fiscal competition leads to MNE location change from a small to a large country, improving
the countries’ joint welfare even though the host country offers the subsidy.
Figures 5 and 8 in Appendix A.4 illustrate the role of trade liberalization in avoiding“harmful tax competition.” When there is a high degree of network externality and τ n f c <
JW
JW
τ BA
< min[τ f c , τ max ] holds, a reduction in trade costs from τ0 ∈ (τ BA, min[τ f c , τ max ]) to τ1 ∈JW
(τ n f c , τ BA
) transforms the fiscal competition form a factor that worsens the regional welfare

into one that improves it. When there is a lower degree of network externality and τ f c <
JW
JW
τ AB
< min[τ n f c , τ max ] holds, a reduction in trade costs from τ0 ∈ (τ AB, min[τ n f c , τ max ]) to τ1 ∈JW
(τ f c , τ AB
) transforms the fiscal competition from increasing regional welfare to decreasing it.

4.3

The individual countries’ welfare

Lastly, we explore how fiscal competition affects the welfare of each country in the region.
Fiscal competition can be harmful to a winning country in some conditions, and it can bebeneficial to a losing country in some other conditions.

23

Let us start with the winning country. If fiscal competition changes the firm M’s location, it will always improve the winning country’s welfare (see Appendix A.3 for the detailed
calculation). This is because the winning country’s efficiency gains from the relocation always dominate the government’s loss arising from granting an investment subsidy. If the
fiscal competition does not change the firm M’s location, no efficiency gains are generated.
Therefore, fiscal competition benefits the winning country if an investment tax is imposed on
the MNE and hurts it if an investment subsidy is granted to the MNE. As Figure 4 shows,the large country as the competition’s winner imposes an investment tax when the network
externality is strong. As the competition’s winner, the smaller country imposes an investment
tax if the trade costs are high.
Proposition 5 summarizes the welfare effects of fiscal competition on the winning country.
Proposition 5. Suppose there are no investment taxes or subsidies without fiscal competition. Fiscal
competition increases the winning country’s welfare if the equilibrium fiscal policy is an investment tax
or fiscal competition leads to relocation of the MNE. Otherwise, fiscal competition reduces the winningcountry’s welfare.
Let us turn to the losing country. If the fiscal competition does not change the MNE’s
location, it will not change the losing country’s welfare because the country is not hosting
the MNE. If the fiscal competition changes the MNE’s location, however, whether the fiscal
competition benefits or hurts the losing country will depend on the amount of trade costs
and the degree of network externality. First, suppose a case involving a strong network effect,ν ∈ (νe, νmax ), where τ̄ n f c < τ ≤ τ f c holds and fiscal competition changes the MNE’s locationfrom country B to A. In this case, consumer gains due to the large network externality area driver of welfare changes, and the MNE’s relocation benefits the losing country, B, if andonly if the extent of the network externality is sufficiently large to satisfy ν > νCS .23
Second, suppose a case of ν ∈ (0, νe) and τ̄ f c < τ ≤ min[τ n f c , τ max ], where fiscal competition changes the MNE’s location from country A to B. We have
WAB ⪌ WAAt A =0⇐⇒ τ ⪌ τ AWAB ≡12{3 − (4n + 3) ν + 3n2 ν} a.
27 (n + 2) − 12 (3n2 + 7n + 6) ν + 2 (9n3 + 23n2 + 15n + 9) ν2(23)n f c max
If τ AW, τ ] holds, the fiscal competition leading to the MNE’s relocation
AB < τ ≤ min[ τ23 This case is possible only if the market size difference is sufficiently small to satisfy 1 < n < 27/25 = 1.08.

24

from country A to B will benefit country A. Such a case only happens if the market size
difference, n, is sufficiently large. When the market size is sufficiently larger in country A,
and trade costs are high, the MNE relocation’s positive effect on local firms’ profits outweighs
the negative effect on consumers.
Proposition 6 summarizes the welfare effects of fiscal competition on the losing country.
Proposition 6. Suppose there are no investment taxes or subsidies without fiscal competition. Fiscal
competition has no effect on the losing country’s welfare if it does not change the MNE’s location.
Fiscal competition benefits the losing country if it leads to the MNE’s relocation from a smaller to alarger country and the network externality is sufficiently strong to satisfy ν > νCS , or if it leads to the
MNE’s relocation from a larger to a smaller country and the trade costs are sufficiently high to satisfy
τ > τ AW
AB . Otherwise, fiscal competition reduces the losing country’s welfare.
Propositions 5 and 6 suggest that the degree of network externality and MNE relocation
critically determine whether fiscal competition is harmful to each country.24 When the network externality is small, fiscal competition that induces the MNE’s relocation is harmful tothe losing country unless the trade costs are sufficiently high. Fiscal competition may evenbe harmful to the winning country if the competition does not change the MNE’s location
unless the trade costs are sufficiently high. This implies that trade liberalization increases thelikelihood of harmful tax competition for competing countries.
When the network externality is large, however, the larger country tends to be the winner,and fiscal competition is more likely to benefit both the winning and losing countries. This isbecause hosting the MNE benefits both the local firm in the larger country and consumers in
the losing country. The same property applies to the effect on regional welfare. Therefore, ourresults provide a strong policy implication, suggesting that strengthening network externality
plays a role in transforming harmful tax competition into beneficial competition. This point
is further discussed in Section 5.3.

5Discussion

We have demonstrated the connection between network externality and fiscal competition
regarding attract FDI. This section discusses additional results pertaining to the equilibrium
24 Table 1 in Appendix 6 summarizes the welfare effects of fiscal competition.

25

Figure 6: Country A’s equilibrium tax
fiscal policy, how the range of the network externality changes the main results, and implications for digital policies.

5.1

The marginal effect of network externality on the equilibrium fiscal policy

Figure 4 shows that stronger network externality enables a large country to impose investment tax in equilibrium, but requires a small country to offer an investment subsidy to win
the competition. It is less clear, however, how an increase in the network externality changes
the level of equilibrium fiscal policies.
For country B, stronger network externality always decreases t∗B . A higher ν decreases t A
because it increases government A’s gains from attracting an MNE. It also decreases country
B’s location advantage and decreases −Ω. For country A, an increase in network externality
can either increase or decrease t∗A . Network externality increases consumers’ gains fromattracting firm M to country B, thereby decreasing t B when ν is small, but increases t B when
ν is large because the smaller network size associated with the MNE being located a smaller
country diminishes consumer gains. Additionally, a higher ν increases Ω because it enhances
country A’s relative location advantage.

26

Figure 6 illustrates a numerical example of how ν changes t∗A .25 When the market size
difference is relatively small (n = 1.1), the higher degree of network externality first decreasest∗A and then increases it. When it is relatively large (n = 1.5), a higher ν value always increasest∗A .26 Therefore, an increase in network externality decreases the larger country’s equilibriumtax when the market difference and degree of the network externality are small. Otherwise,
it increases the equilibrium tax on the larger country.
When both ν and n are small, a marginal increase in ν raises country B’s gains fromhosting the MNE because the network externality increases the amount of consumption incountry B and thereby amplifies country B’s consumers’ gains from saving trade costs. Consequently, a larger network externality intensifies fiscal competition and induces country A
to set a lower t∗A . When ν is sufficiently large, however, a further increase in ν will reducecountry B’s incentive to host the MNE because country A’s hosting of the MNE would hurt
the consumers in country B less or may even benefit them due to the network effect. These
results suggest that we need to promote digitalization and ensure that ν is sufficiently large
to avoid harmful tax competition.

5.2

Country-specific network externality

In the main analysis, we assumed that consumption network externality arises at the international level. However, some factors, such as the physical and cultural distances between
countries, language differences, and regulation differences, may limit cross-border extensionsof network externality.
This section considers the other extreme case, where network externality only works
within each country. The modified utility function in country i is given by ui = θ + νYi − pi .
and the corresponding inverse demand function becomes pi = a + νYi − X Min+i XLi . The equilibrium outcomes based on this modified setting are provided in Appendix A.5.
jjjb (= X + X ) denote the total consumption of the network goods. We have
Let Y
i
Mi
Li
bA − Y
bB =
Y
A
A

nτ
> 0,
3 − 2nνbBB − Y
bBA =
and Y

τ
> 0.
3 − 2ν

(24)

25 The parameters are set at a = 1 and τ = 0.05 such that country A wins the fiscal competition for anyν ∈ [0, νmax ). νmax = 5/7 ≈ 0.71429 for n = 1.1 and νmax = 0.6 for n = 1.5.

∗3[(5a−2τ )n2 −2τn−3(3a−2τ )]26 We have ∂t A∂ν ν=0 = 2(n+1)(3n2 −4n−3) a+{3+11n−3n2 +3n3 }τ , where the denominator is positive only if n <
n
o
√
∂t∗
n+1)(3n2 −4n−3) a a2+ 13≈ 1.8685 and τ < min − 2(3nhold. If these conditions are met, we obtain ∂νA⋛
3 −3n2 +11n +3 , 2
3
ν =0
√
2
2
+13τ
0 ⇐⇒ n ⋛ τ + 45a5a−−48aτ
.
2τ

27

Figure 7: Equilibrium location under country-specific network externality
The network size of country i is larger when country i hosts the MNE. Therefore, the increased
network externality always intensifies fiscal competition because it increases each country’s
consumers’ gains from attracting FDI. This property deviates from the benchmark model,
in which the MNE’s location in the larger country always realizes the largest network size.
Therefore, the MNE’s location in country A never benefits consumers in country B, although
it can still benefit the local firm in country A.
As shown in Figure 7, however, we can obtain results that are qualitatively identical tothose of the baseline model regarding the equilibrium fiscal policy and the fiscal competition
winner: Country A imposes a tax when the network externality is very strong, whereas country B imposes a tax when the network externality is weak, and trade costs are high. The fiscal
competition induces the MNE’s relocation from country A to B when the network externality
is weak, but it induces relocation from country B to A when the network externality is strong.
One departure from the benchmark analysis is the effect of trade liberalization on country
A’s equilibrium fiscal policy. Here, τ tA is decreasing in ν, whereas in the benchmark model,
it is increasing in ν. Therefore, trade liberalization from τ0 (> τ tA ) to τ1 (< τ tA ) changes thecountry A’s equilibrium fiscal policy from a tax to a subsidy, whereas it changes country
B’s equilibrium policy from a subsidy to a tax. Under cross-border network externality inthe benchmark analysis, country A loses its location advantage, Ω, under sufficiently hightrade costs. This is because the MNE is able to weaken the competition with the local firmby locating itself in country B under high trade costs. Therefore, country A imposes a tax in28

equilibrium with the low trade costs.
Under country-specific network externality, however, the MNE significantly loses its gains
from the network effects by locating itself in country B under high trade costs. This effectmagnifies country A’s location advantage, and there is a case where country A imposes a tax
under high trade costs. However, as in the benchmark analysis, country A always imposes a
tax irrespective of the trade costs if the network externality is sufficiently strong.

5.3

Implications for digitalization

We have argued that network externality changes the nature of tax competition for FDI. Although many studies have explored factors affecting fiscal competition, little discussion has
addressed its relation to the recent development of digitalization and digital policies.
A feature of the recent digitalization is the development of two-sided markets, where users
and service providers are connected through platforms. Game consoles, mobile phones, andpersonal computers are examples of these platform products, which consumers use to enjoy
online services such as games, apps, and online communication tools. In two-sided markets,an increase in the number of a platform’s users benefits service providers, stimulating theirentry into the platform, which, in turn, benefits the users and increases their demands. The
progress of digitalization magnifies this indirect network effect.
Our model considers the direct network externality. However, as is briefly mentioned
in the Introduction, ν can implicitly represent the degree of indirect network externality: νcaptures the extent to which an increase in the platform product consumption improves users’
utility by expanding the variety or quality of online services.
Certain digital policies would affect ν. Restrictions on cross-border data flows, such as
China’s local storage requirements, increase the cost of providing services and decrease ν.
Hence, facilitating data flows is an important policy agenda. For instance, OECD (2022) has
discussed the policy challenges of pursuing cross-border data flows with trust. There areother factors limiting network externality. Due to high commissions, many mobile device
app providers only supply their services on a single platform (i.e., single-homing).27 Several
countries’ antitrust authorities in several countries, such as Japan and Korea, have questioned
the high commission rates Apple and Google impose on developers and now require these27 Hyrynsalmi et al. (2016) investigated the developers of mobile apps available in Apple’s App Store, theGoogle Play Store, and the Windows Phone Store and showed that about 95% of developers are single-homing.

29

platforms to refrain from forcing customers to use their native payment systems.28 Indeed,
the Digital Market Act passed in the European Union aims to prevent large platforms fromengaging in unfair practices.29
These policies will contribute to increasing ν, which implies that they are important not
only for amplifying network externality but also for avoiding the harmful effects of fiscal
competition.

6

Conclusion

The policy debate on “harmful tax competition” is essential in international taxation. The
question of how progress in digitalization affects the winner and welfare effects of fiscal
competition aimed at attracting MNEs is important, but analyses of digitalization are scarce.
This study investigated the consequences of fiscal competition for FDI in the presence of
network externality as network goods are traded and consumed globally. The findings areuseful for considering optimal fiscal policies in a digitalized world.
The results demonstrate that network externality increases larger countries’ probability of
attracting more MNEs. With strong network externality, MNEs in larger countries may benefit local firms and consumers in smaller countries. Fiscal competition decreases the likelihoodof a larger country hosting an MNE when the network externality is small, but notably, thisincreases the likelihood when the network externality is large. When the network externality
is significant, a larger country always wins the fiscal competition by imposing a positive investment tax. A location change induced by fiscal competition improves the total welfare, but
it may worsen the losing country’s welfare and the joint welfare of potential host countries.
If the network externality is significant, an MNE location change from a smaller to a larger
country will improve the joint welfare, and there is a case where it improves both countries’
welfare. If the network externality and trade costs are relatively small, the MNE’s location
change from a larger to a smaller country will worsen the losing country’s welfare as well as
the two countries’ joint welfare.
This study sheds new light on policy debates regarding tax competition in a digitalized
world. There have been concerns that tax competition distorts FDI patterns and erodes the
28 Seehttps://asia.nikkei.com/Business/Technology/Apple-and-Google-warned-on-app-stores-byJapan-antitrust-watchdog.
29 Seehttps://commission.europa.eu/strategy-and-policy/priorities-2019-2024/europe-fitdigital-age/digital-markets-act-ensuring-fair-and-open-digital-markets_en.

30national tax basis. Our results suggest that “harmful tax competition” is less likely when
the network externality is large; that is, with sufficiently large network externality, tax competition promotes MNEs’ location choice of larger and more competitive countries, enlarges
the overall network size, benefits consumers in those larger countries, and improves competing countries’ overall welfare. Further, MNEs’ location in these larger countries can benefit
local firms and consumers in smaller countries. The larger country that wins the tax competition can set a positive investment tax and earn tax revenue when the network externality
is sufficiently large. These results suggest that promoting digitalization to enhance network
externality is important for avoiding the harmful effects of tax competition.
This study’s novelty lies in its status as the first to consider the effect of digitalization on
fiscal competition for FDI, but there remain some elements that have not been considered.
For instance, it would be intriguing to explicitly consider two-sided markets and explore
how platforms’ commissions charged to service providers affect fiscal competition. Introducing product differentiation and product-specific network externality can provide additional
insights. Estimating network externality is a tall order, but our study provides empiricallytestable results regarding how digitalization affects MNEs’ location choices and the outcomesof tax competition. We leave these points for future research.

31

Appendix
A.1 Proof of Lemma 3
From Eqs.(16) and (19), we haveτn f c − τ f c ={3 − 2 ( n + 1) ν } Ψ1 ( ν ) n f c f cτ τ ,72 (n − 1) {2 − (n + 1) ν} awhere Ψ1 (ν) = 18 (n + 1) − {3 15 + 14n + 15n2 − 2 (n + 1) 9 + 10n + 9n2 ν}ν. We have
= 54a(n2 − 1)/{(3 + 11n)(7n − 3)} > 0 and τ n f c − τ f c= 0. Asτn f c − τ f c
ν =0
ν=νmaxΨ (ν) is U-shaped in ν, Ψ′ (0) = −3 15 + 14n + 15n2 < 0, and Ψ′ (vmax ) = 9 (n + 1)2 > 0,
there always exists a cut-off level of v, ve (∈ (0, vmax )), such that τ n f c > τ f c holds for v ∈ (0, ve),
τ n f c = τ f c at v = ve, and τ n f c < τ f c for v ∈ (ve, vmax ).

A.2 The effect of fiscal competition on total welfarejjj

Let TW j = WA + WB + Π M be the total welfare, which comprises the welfare of the twocountries in the region and the MNE’s profits, when firm M is in country j. By comparing
the total welfare when firm M locates in country A to that when firm M locates in country B,
we haveA

TW − TW

B=

A
WAA + WBA + Π M−

WAB + WBB + Π BM





A
= ΠM
− WAB − WAA − {Π BM − (WBA − WBB )}A= ΠM− t A − (Π BM − t B )A= ΠM(t A ) − Π BM (t B ).

A ( t ) ⪌ Π B ( t ). By (19),We have TW A ⪌ TW B ⇐⇒ Π M
A
M B

TW A ⪌ TW B ⇐⇒ τ ⪋ τ f c .

Therefore, the equilibrium locations with policy competition always maximize the total welfare.

32

A.3 Proof of Proposition 5
When fiscal competition does not change the MNE’s equilibrium location, it is straightforwardthat the winning country’s welfare increases if it imposes a tax and decreases if it grants a
subsidy in equilibrium. When fiscal competition leads to the MNE’s relocation from country
A to B, we haveA
− Π BM ) − CS BA
WBB − WBA = CSBB + t A − (Π M
A
= CS BA + CSBB + Π BM + Π BL − (CS AA + CSBA + Π M+ Π LA )= TW B − TW A > 0.
A + Π A ). Since MNE relocation always improves the total
Note that t A = CS BA + Π BL − (CS A
L

welfare (TW B > TW A ), WBB > WBA holds. Similarly, by using t B = CSBA − CSBB , we havea welfare change in country A when fiscal competition leads to the MNE’s relocation fromcountry B to A:
AA
WAA − WAB = CS A
+ Π LA + t B + (Π M
− Π BM ) − (CS BA + Π BL )A
= CS AA + CSBA + Π M+ Π LA − (CS BA + CSBB + Π BM + Π BL )= TW A − TW B > 0.
Since TW A > TW B holds with this relocation, WAA > WAB holds.
JW
A.4 The case for τ BA
< τ̄ n f c with weak network externality.

In the example depicted in Figure 5, the MNE’s location change from country B to A neverimproves the joint welfare. When the market size difference is small, the regional welfare
gains from the MNE’s relocation to a smaller country are small, and country A’s subsidy
payments dominate those gains.
Figure 8 illustrates another example with a relatively large market-size difference (n =1.5). In this case, the MNE’s relocation to a smaller country generates larger welfare gains
and also requires a smaller subsidy payment to attract the MNE. In this case, the MNE’s
policy-induced relocation from a larger to a smaller country improves the regional welfare if
JW
the trade costs are sufficiently high to satisfy τ > τ AB
; however, the relocation also improvescountry A’s welfare because τ̄ n f c < τ AW
AB holds. Even with a large market size difference, we
33Figure 8: Policy-induced location changes and joint welfare (n = 1.5)
still have the range of ν and τ where the MNE’s policy-induced relocation from a smaller toa larger country improves the two countries’ joint welfare.
Table 1 shows all cases of the welfare effects of fiscal competition.

A.5 Country-specific network effects
In the modified model, firms’ equilibrium supplies become30
a−τ
A
A
b MB
b LB
X
=X
=
,
3 − 2ν
n( a + τ − nντ )
B
b LA
X
=
,
3 − 2nνa − 2τ + ντ
B
b LB
X
=
.
3 − 2ν

an,
3 − 2nνn( a − 2τ + nντ )
B
b MA
,
X
=
3 − 2nνa + τ − ντ
B
b MB
X
=
,
3 − 2ν

A
A
b MA
b LA
X
=X
=

These supplies lead to (24).
Concerning the effect of MNE location on the local firm in country A, we havenνΓ Lb LA − Πb BL = − {2(n − 1) a + (n + 3)τ } +Π99(3 − 2ν)2 (3 − 2nν)2where Γ L = −54{(n2 − 1) a − n2 τ } + 9(n + 1){8(n2 − 1) a − (5n2 + 3n − 3)τ }ν − 12n(n +30 In the modified model, we redefine the upper-bounds of ν and τ as νmax = 3 and τ max = a , respectively,2n2− νto secure positive supplies of all firms in all markets.

34

Welfare Effect

WinnerPolicyRelocation Other Conditions
Total
Always beneficial
Large/Small
Tax
Yes/NoBeneficial
Large
Large ν & small τ
Yes
Small*
Small ν & large τRegionLarge/Small
SubsidyNo
HarmfulLarge
Small ν & large τ
Yes
Small
Large ν & small τ
Tax
Yes/NoLarge
Beneficial
Subsidy
Yes
Small*
Tax/Subsidy
Small ν & large τLarge Country
Large
SubsidyNo
HarmfulYes
Large ν & small τ
Small
Tax/Subsidy
No effect
No
Tax
Yes/NoSmall
Benefical
Subsidy
Yes
Large
Tax/Subsidy
Large νSmall Country
Small
SubsidyNo
HarmfulYes
Small νLarge
Tax/Subsidy
No effect
No*These cases only happen if the market-size difference (n) is sufficiently large.
Table 1: Summary of the welfare effects of fiscal competition

1){8(n − 1) a − (5n − 3)τ }ν2 + 4n2 {8(n − 1) a − (5n − 3)τ }ν3 and Γ L |ν=νmax = {9(n − 1)2 (4a −3τ }/(4n) > 0. Therefore, the local firm benefits from the MNE’s location choice of a large
country with a very strong network externality.
Without fiscal competition, we calculate country A’s fundamental location advantage overcountry B asA
Ω = (Π M− Π BM )t A =t B =t=4{(n − 1) a − nτ }τ
τνΓ M
+
,
9
9(3 − 2ν)2 (3 − 2nν)2where Γ M = 54{5(n2 − 1) a − (2n2 − 3)τ } − 9{8(n − 1)(2n2 + 7n + 2) a − (7n3 + 16n2 − 24n −9)τ }ν + 12n(n + 1){16(n − 1) a − (7n − 9)τ }ν2 − 4n2 {16(n − 1) a − (7n − 9)τ }ν3 . The thresholdlevel of location choice without fiscal competition, τ n f c , is given byΩ ⋛ 0 ⇐⇒ τ ⋚ τ n f c ≡2a(n − 1)(18 − 9(1 + n)ν − 4nν2 )ζn f cwhere ζ n f c ≡ 36n − 6(6n2 + 8n + 3)ν + (9n3 + 48n2 + 40n + 9)ν2 − 12n(n + 1)2 + 4n2 (n + 1).

35

The most generous fiscal policy of country A becomes
WAA ≥ WAB ⇐⇒ t A ≥ t A ≡ −ντξ A{4a − 3(n + 2)τ }τ
−,18
9(3 − 2ν)2 (3 − 2nν)2where ξ A ≡ 54(3n2 + 1) a − 9{8(1 + n + 3n2 ) a − 3(n3 − 1)τ }ν + 12n(1 + n){8a + 3(n − 1)τ }ν2 −4n2 {8a + 3(n − 1)τ }ν3 . The most generous fiscal policy of country B becomes
WBB ≥ WBA ⇐⇒ t B ≥ t B ≡ −(4a − 3τ )τ 2ντ (3 − ν)(4a − 3τ ).
−18
9(3 − 2ν)2Given the most generous fiscal policies, we obtain,AΠM(t A ) ⋛ Π BM (t B ) ⇐⇒ τ ⋚ τ f c ≡8(n − 1)(9 − 4nν2 ) a,ζ fc

where ζ f c ≡ 9(11n + 3) − 12(9n2 + 14n + 9)ν + 4(9n3 + 39n2 + 47n + 9)ν2 − 48n(n + 1)2 ν3 +16n2 (n + 1)ν4 .
As shown in Figure 7, the modified model demonstrates a similar pattern of firm M’s
location choice and of the equilibrium fiscal policies.

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