Tax Competition with Heterogeneous Firms
Richard E. Baldwin
Graduate Institute, Geneva
Toshihiro Okubo
Kobe University, RIEB

February 2009; first draft, September 2007 1
ABSTRACTThis paper studies tax competition in a setting that allows for agglomeration
economies and heterogeneous firms. We find that the Nash equilibrium involves
the large country charging a higher tax than the small nation, with this rate being
too low from a social point of view. Tighter integration of markets leads to an
intensification of competition, a drop in Nash tax rates, and a narrowing of the gap.
Since large, productive firms are naturally more sensitive to tax difference in ourmodel, large firms are the crux of tax competition in our model. This also meansthat tax competition has consequences for the average productivity of the big andsmall nations’ industry; by lowering tax rates, the small nation can attract highproductivity firms.
JEL H32, P16.
Keywords: Firm heterogeneity, Nash equilibrium tax, Stackelberg equilibrium tax,
collusion, average productivity

1. INTRODUCTION
The last few decades have seen OECD countries engaged in competition over corporate tax
rates. These nations strive to balance tax revenue goals with their desire to avoid losing firms
to low-tax nations. This has made corporate tax competition an important issue in both thetheoretical and empirical public finance literature.
In some sense, one can view the theory development as capturing an ever wider range of realworld considerations that seem to be critical to the public debate. The early, classic taxcompetition models such as Zodrow and Mieszkowski (1986) and Wilson (1986) – see
Wilson (1999) for a survey – crystallised our thinking on the basic race-to-the-bottom logic.
These models were not designed to capture the interaction between goods market integrationand the intensity of tax competition. As this concern played a key role in the intra-European
debate during the late 1980s and early 1990s, the theory literature responded with models that
capture this interaction.

1

We would like to thank Rikard Forslid, Gianmarco Ottaviano, and Masahisa Fujita for helpful comments andsuggestions as well as participants in seminars at Tohoku University, and Kobe University for their comments.

Tax and heterogeneous firms

2

While there are several ways of theoretically connecting international tax competition andgoods market integration, one recent line relied on models with agglomeration economies
where the degree of goods market integration has an important influence on the location offirms. One novel feature of these models was that they allowed for a rich set of outcomes
between trade integration and tax competition. 2 For instance, in some cases, one observes firsta ‘race to the top’ and then a ‘race to the bottom’ as trade costs fall. This is driven
fundamentally by a well known feature of the agglomeration models, namely that
agglomeration rents are greatest at intermediate trade costs. Since agglomeration rents are
quasi-rents, nations can tax them up to a point without the firms relocating abroad to escape
the tax.
More recently, focus has turned to taxation and difference among firms, in particulardifference related to size and productivity. For instance, Ireland has the lowest rate in the EU
at 10% and this has attracted many productive firms, whose average productivity is thehighest in Europe (O’Mahony and Van Ark, 2003). Indeed, the public policy debate oninternational tax competition has long focused on large firms based on the premise that large
firms are both the most likely to move in response to tax differentials and the sort of firms thata nation would be least happy about losing.
Our paper considers tax competition with a range of firm sizes. Our model is inspired by theso-called Heterogeneous Firms Trade (HFT) model introduced by Melitz (2003). Firms areheterogeneous in their size and productivity. In our tax model, which is automatically marked
by agglomeration economies, the largest firms are the most sensitive to international tax gaps
and so the cutting edge of the competition very naturally concerns large firms. Moreover,introducing firm heterogeneity allows us to consider the average productivity effect of firm
relocation by size. The key is that size and profits differ across firms, so corporate tax gaps
affect big and small firms in different ways.
The paper closest to our contribution is Burbidge, Cuff and Leach (2005, 2006). Theseauthors model the impact of taxation in the framework of heterogeneous firms, i.e. different
firm sizes. However, they do not consider monopolistic competition a la Melitz (2003) but
rather work with perfect competition. Moreover they assume that firm productivity
differences are location-specific as well as firm-specific, so the firm’s productivity changes
when it changes location. Our early paper, Baldwin and Okubo (2008), uses the basic HFT
model with firm mobility, but that paper studied base-widening/rate-lowering tax reforms.
Our current paper goes beyond this by introducing strategic interactions between tax setting
authorities as in Devereux et al. (2008), although our model differs sharply from this paper inthat ours involves heterogeneous firms.
To preview the paper’s value added, we propose a setting where large firms are at the crux ofthe tax competition, as often discussed in the policy literature. Second, our framework
redresses one of the problems of tax competition with homogenous goods model andagglomeration rents (e.g. Baldwin and Krugman 2004), namely they may have no Nashequilibrium. The basic problem with working with homogenous firms is that all the firms
view the tax gap in the same way; if one wants to go, they all do. With heterogeneous firms,
the firm’s sensitivity to tax gaps varies with firm size, with large firms being the mostsensitive to tax gaps.

2

For instance, Ludema and Wooton (1998), Kind, Midelfart-Knarvik and Schjelderup (1998), Trionfetti (2001),
Forslid and Midelfart-Knarvik (2001), Ottaviano and Van Ypersele (2005), Andersson and Forslid (2003), andBaldwin and Krugman (2004).

Tax and heterogeneous firms

3

The rest of the paper is organised in five sections. The next introduces the basic economic
model without taxes in order to characterize the relocation tendency of firms according to sizein the simplest possible setting. Section 3 studies the impact of exogenous tax differences onfirm location choices. Section 4 explores tax competition, and Section 5 considers therelationship between tax competition and average productivity. Our concluding remarks are in
the last section.

2. THE BASIC MODEL: NO TAXATIONThis section introduces the basic economic framework; it can be thought of as combination of
the agglomeration model of Martin and Rogers (1995) and the HFT model of Melitz (2003).
We work with two nations (North and South) each with two sectors (manufacturing and thenumeraire sector). The numeraire-good sector is meant to be uninteresting; it is marked byconstant returns, homogeneous firms, perfect competition and costless trade with labour as its
only input. Its role is to alleviate general equilibrium considerations as it equalises unit labourcosts internationally, balances trade and eliminates income effects (via quasi-linear
preferences).
Manufacturing is the focus of the analysis, so we allow for a range of firm productivity levels,
imperfect competition, trade costs and scale economies. Specifically, firms’ marginal costs
are flat, international trade is subject to iceberg trade costs, and firms compete according to
Dixit-Stiglitz monopolistic competition. We assume the manufacturing sector is capitalintensive since each manufacturing firm requires one unit of capital (its fixed cost); variable
costs involve only labour. Since each firm requires a unit of capital and each firm has adifferent variable cost, it is useful to think of the capital as a blueprint that implies a firmspecific marginal cost.
Labour is immobile across nations but capital can move without costs between North andSouth. Since there is one unit of capital per firm, capital mobility is tantamount to firm
relocation. To avoid issues of arising from where profits are spent, we assume all capital isowned by labour. That is, while capital is mobile, capital owners are not, so all capital
rewards are spent in their native region.
Importantly, firms have heterogeneous marginal costs. In Melitz (2003) the distribution ofthese marginal costs is endogenised, but here we assume each nation’s distribution is fixed –part of its endowment. Finally, we assume that the nations are asymmetric in size (North isbigger), but they are endowed with identical relative factor supplies. This makes the Northlarger in a pure sense (its endowment of labour and capital are proportionally larger than theSouth’s) and rules out Heckscher-Ohlin motives for trade and/or capital movements.
The basic forces in this model are now well understood. The scale economies and trade costs
make firms want to locate in the big market, all else equal. The imperfect competition, bycontrast, makes firms want to locate away from their competitors, all else equal. The tension
between the pro-agglomeration force and anti-agglomeration force is regulated by trade costs.
On one hand, the cost disadvantage stemming from having to ship to customers in the othermarket rises with trade costs and this tends to favour agglomeration of all firms in one market.
On the other hand, high trade costs provide protection from competitors located in the othermarket and so tend to favour a dispersed outcome.
More formally, tastes of the representative consumer in each region are:

Tax and heterogeneous firms

4

1-1/
U   ln C M  C A , C M    ci
di 
 i


1 /( 1-1/ ),1    0,   1

where CM and CA are, respectively, consumption of the composite of M-sector varieties andconsumption of the A-sector good, and  > 1 is the constant elasticity of substitution between
any two M-sector varieties;  is the set of all varieties produced (pre-determined since eachvariety requires a unit of capital and the world capital stock is fixed).
Firm-level heterogeneity in our model stems from differences in firm’s marginal costs. Thus,
although all the Dixit-Stiglitz varieties enter consumers’ preferences symmetrically, the costof producing of each variety is different. The unit labour requirements are variety/firm
specific and denoted as aj for firm j. The distribution of firm-level efficiency, which part ofeach region’s endowment, is assumed to be Pareto:G[a]  (

(1)

a
a0



),

1  a 0  a  0,   1

Here a0 is the scale parameter (highest possible marginal cost) and  is shape parameter. We
normalise a0 to unity without loss of generality. For simplicity, G[a] is identical for the twonations.
While the distribution of a’s is the same in both nations, the big region (North) has morevarieties with each level of marginal cost. The resulting distribution of a’s can be seen in
Figure 1. Note that the distribution in the North is nG[a], in the South it is n*G[a]. Of course
this means that the total mass of firms in the North and South are ‘n’ and ’n*’, respectively. 3nG[a]frequency

n*G[a]
G[a]

1

0

a0=1

‘a’ (=
marginal cost)

Figure 1: Endowed distribution of capital and marginal costs in North and South.

2.1. The no-tax equilibrium and relocation tendencies
Constant returns, perfect competition and zero trade costs in the numeraire sector equalise
wages across countries (wages in terms of the numeraire). We choose the units of this goodsuch that w = w* = 1, so all differences in firms’ production costs stem from differences in thea’s.
Utility maximisation generates the familiar CES demand functions in the manufactures sector.
These, together with Dixit-Stiglitz monopolistic competition imply ‘mill pricing’ is optimal
and a firm’s operating profit is 1/ times firm-level revenue. Thus, the operating profit of a
North-based firm with marginal cost ‘a’ is:3

Since we take the range of varieties to be continuous, we speak of the ‘mass’ of firms with a particularmarginal cost. We assume that the mass is the same for every level of marginal cost (this is demonstrated in
Melitz (2003) as the outcome of an endogenous entry/exit process).

Tax and heterogeneous firms

(2)

5

a
a


)1
(
)1
(
1
E * ;
 * [a ]   1  1 / E  (1  s E ) 1  1 /1-
1-

pi* di
 i pi di


i



   1The first term in this expression is the value of firm-specific sales in the Northern market; thisrises as the firm’s ‘a’ falls; E reflects the total Northern market expenditure. The second termshows the firm’s export sales; the firm’s price includes the iceberg trade cost raised to 1-, thedenominator involves prices in the export market (the p*’s), and the relevant expenditure isSouthern expenditure, E*.
There are several important features of (2). First, all firms earn positive operating profit inequilibrium and this is the reward to capital, i.e. the Ricardian rent. Second, the most efficientfirms, i.e. firms with low marginal costs, are the largest in the sense that they sell the most.
Third, profitability and operating profits are proportional to sales.
In the initial situation where no capital mobility (i.e. delocation) is allowed, Northern andSouthern operating profit, as a function of the firm’s ‘a’, can be written as: 4
(3)

s


 [a]  a 1  E (1  s E )  E w
 (1  s E )  E w
E*
1   s
 w ; sE  w
 w ,  [a]  a  E 
*  K *  K E 

Here we have introduced sE as shorthand for the North’s share of world expenditure (we adopt
the convention that North is bigger so sE>½), Kw is world endowment of capital, and the ’s
are the denominators of the North and South CES demand functions ( is a mnemonic fordenominator):
11

  s K  a 1 dG[a ]  (1  s K )  a 1 dG[a];
0

0

1

1

0

0

*  s K   a 1 dG[a ]  (1  s K )  a 1 dG[a] ;

sK 

K
,
Kw

where sK is the North’s share of Kw. Solving the integrals with (1) and assuming 1 -  +  > 0
so that the integrals converge, we have: 5(4)   s K   (1  s K ) ; *   s K  1  s K ; s K 


K
, 
0
w
1  K

Firms move to the region with the highest operating profit. Starting from the initial situation
where no relocation has occurred, (3) and (4) imply that the operating profit gap is:12  s   (1   ) E 2( [a ]   * [a ]  a 1 )0w   K  (1   ) s   1  s  s 
wwhere ‘s’ is the north’s ‘size’, namely its share of world E and K. Notice that the first term inparentheses is positive since  < 1, and  and  are positive by our regularity conditions. The
numerator of the second term is positive since s>½, and the denominator is positive since boths and  are lie between zero and one. Thus -* is always positive in the initial situation, i.e.

45This simplification uses mill pricing and cancels the (1-1/) terms.
Since firms are atomistic, the first firm to move has no impact on the ’s.

Tax and heterogeneous firms

6

there is always a tendency for firms to move to the large region. 6 Importantly, the -* gap ishighest for the largest firms, i.e. those with the smallest marginal cost, ‘a’. In other words, themost efficient Southern firms are the ones who gain the most by moving to the big market. Tosummarise, the first firms to relocate from the small region (South) to the large region (North)
are the most efficient small-region firms.

2.2. The Location equilibrium
As less and less efficient Southern firms move to the North, the degree of competition rises in
the North and falls in the South. This tends to make the North less attractive and the South
more attractive, i.e. the relocation extinguishes the forces that produced it. To characterise thelocation equilibrium, we find the level of ‘a’ for which the incentive to relocate drops to zero.
Once relocation occurs, the formula for the profit gap is more complicated than (4). Defining
the range as firms that have moved from South to North as [0,aR] (i.e. zero to aR defines therange of firms that have moved by referring to their marginal cost), we have that the  and *after relocation are:
aR

1

1

  s  a 1 dG[a ]  (1  s ){ a 1 dG[a ]    a 1 dG[a ]},
0

aR

0

1

aR

1

0

0

aR

*  s  a 1 dG[a]  (1  s ){  a 1 dG[a ]   a 1 dG[a ]};Kw 1

The first term in the top expression reflects the prices of North-made varieties sold in the
North; the ‘s’ in front of the integral reflects the north’s share of firms, i.e. its share of world
capital, namely sK, but by symmetry of relative endowments sK equals the relative size of thenorth’s market, i.e. ‘s’. The second integration in the top expression reflects the prices ofSouthern varieties produced in the North (Southern firms with a’s in the range [0,aR] haverelocated). The third integral reflects the prices of Southern varieties that are made in theSouth and exported to the North. The second bottom expression is isomorphic, but reflects thesituation in the South.
Solving the integrals using (1):(5)

    s  (1  s )aR   (1  s )(1  a R )  ,*    s   (1  s )aR  (1  s )(1  aR )  ,  1  Thus the operating profit gap is a function of aR, so the ‘location condition’:(6) [a R ]   * [a R ]  0

where [a R ]  a R

1

 sE
1  sE  E w
1  sE  E w
sE
1 
*



,  [a R ]  a R  
 * [a R ]  
 [a R ]  * [a R ]   [a R ]The location condition characterises the equilibrium range of firms that have moved from theSouth to the North. The solution (which defines the level of ‘a’ where firms are indifferent
between locations) is:

6This result is known as the ‘home market effect’ in international trade, e.g. Krugman (1980).

Tax and heterogeneous firms

(7)

7

1
2 ( s E  )

2 ,
aR 
(1   )(1  s E )s n  s E  (1  s E )a R



where sn is the share of all firms located in the North in equilibrium. Note that aR rises with 
so more inefficient firms find it profitable to relocate as trade gets freer. Full agglomeration
occurs when  equals or exceeds the sustain point, S:

S 

(8)

1  sEsE

Figure 2 shows the impact of this agglomeration on the distribution of firm efficiencies bymarket. The diagram is drawn for an intermediate level of trade freeness, i.e. one where some
but not all Southern firms have relocated to the North. 7
Figure 2: Geographic distribution of firm efficiency with free delocation.

(n+n*)G[a]nG[a]North (big)

0

aR

a0

‘a’

n*G[a]South (small)
0

aR

a0

‘a’

The location condition implies sE/(1-sE)=*/. Since the CES price index for manufactures in
the North and South are P=1- and P*= (*)1-, the price index is lower in the North than it
is in the South in equilibrium. Since the price of the numeraire good and labour are equalised,
this implies that real incomes are higher in the North than they are in the South.
Discussion

A number of features of this equilibrium are attractive when it comes to the analysis of tax
competition. For example, compared to the small South, the large North is richer, has firmsthat are more efficient on average, and has a disproportionate share of the ‘good’ firms, i.e.
large efficient firms with above-average profitability. The North is also a net exporter ofmanufactures and has a higher share of its work force in manufacturing. This is a second-best
7

Note that the delocation process tends to raise the average efficiency of industry in the big region while it
lowers the average efficiency in the South. This is what Baldwin and Okubo (2006) call ‘spatial selection’.

Tax and heterogeneous firms

8equilibrium since the imperfect competition means that too few resources are devoted to the
manufacturing sector as opposed to the numeraire sector.

3. EXOGENOUS TAXATION
We now turn to considering the impact of taxes on the equilibrium location of firms and the
distribution of firm types. For simplicity, we start from full agglomeration, i.e. when all
manufacturing is in the North since trade is freer than the level necessary to sustain full
agglomeration, i.e.  > S.
Consider a situation where firms in the bigger, richer North pay higher profit taxes than thosein the South. To keep things simple, assume Southern taxes are zero. In this case, whatmatters for location is the post-tax profit gap for a North-based firm. This is given by:
1  sE  E
sa1  E  T,*  w

T  1 twhere T is the tax factor, one minus the corporate tax rate. The net profit for a South-based
firm is identical to the untaxed case, so the incentive to move to the North is:( 9)

1  sE  E w
sE 1  s E  E w
s1 
a 1  E  
T

a

 0,




*  
*   

all firms stay in the North and pay tax. Since the threshold we wish to solve for, aR, enters the’s to the power of 1 -  +  and directly to the power of 1 - , we cannot solve the value of‘a’ that sets the profit gap to zero. Numerical solutions, however, are readily available.

3.1. The tax revenue curves
Simulations (not shown) confirm the intuitive result that the equilibrium range of Southernfirms in the North falls as the Northern tax rate rises. Since it is the biggest Southern firmsthat have the most to gain from local access to the big Northern market, raising the Northern
tax pushes out the biggest, most efficient Southern firms first. This creates a connection
between average productivity and the corporate tax rate. Specifically, lowering the Northernrate tends to raise the average productivity of North’s manufacturing sector and lower theSouth’s.
As a background for tax competition, we characterise an important threshold tax rate namely
the rate just low enough to attract all Southern firms to the North. We call this the fullrelocation tax rate and denote it as Tfr .
As all firms are in the North, when T less than or equal to Tfr, we can solve the location
condition analytically to get:(10)

T fr 

 2s  1  s
For taxes in the range T < Tfr, all manufacturing firms are in the North, so tax revenue is linear
in T, specifically:(11)

Tax revenue 1

(1  T ) ;T  T frTax and heterogeneous firms

9

If the North raises taxes beyond the Tfr point, the Northern tax base falls with higher tax rates.
This means that tax revenue is hump-shaped in terms of the tax factor T and there exists a
Northern tax rate at which its tax revenue is maximised.
To explore the latter, note that the largest firms are naturally most sensitive to taxation – after
all they pay the most taxes – so they are the ones to leave the North first when T rises above
Tfr. Thus all firms with a’s from 0 to aR relocate to the South (both those that were originallyin the North and those originally in the South). Solving the location condition, the cut off
level is related to the North’s tax rate by:a R 

(12)( 2  1) s  T  1(1   )((1   )(T  1) s  T  1)

In this case, the tax revenue is related to aR according and T to:
1

North Tax Re venue  

aR

(13)



B  B a

1

*

1

(1  T )dG[a ](1  s )B  B * (1  T )(1  a R )


where
B

s
1 s
and B *  (a R  1  a R ) (a R   (1  a R ))

We plot Northern tax revenue against the Northern tax factor in Figure 3. This shows that therelationship is hump-shaped overall and linear for T’s beyond below the rate. 8 Higher tax
rates increases tax revenue, while higher tax leads to firm relocation to south and decreases
tax base and thus fall Northern tax revenue.
Figure 3: Tax Revenue Curves.

Tax Revenue
Tax Revenue Curve (North)

0

fr

T

T=1-t
1

max

T

As it turns out, we can analytically identify the tax factor that maximise Northern tax revenue.
This is:8

The parameter values chose for the simulations that generated the figure are σ=2, ρ=2, =0.75 and s=0.6.

Tax and heterogeneous firms

(14)

10

T max  s  (1  s ) 2   (1   ) 2 (1   )2 (1  s ) ss  (1  s ) 3

To summarise, we write:
Result 1: Assuming the South imposes no tax, the Northern tax revenue curve is humpshaped (“Laffer Curve”). The tax rates that maximise tax revenue vary with the relative
size of the North and the freeness of trade. As the big country gets relatively bigger, therevenue maximizing tax rate rises, as long as trade is not too free.

4. CORPORATE TAX COMPETITIONIn this section, we consider taxes set in the course of a strategic interaction among
governments taking the relocation tendency of firms as given.
So far we have artificially prevented the South from taxing firms. If the North’s tax rate is low
enough to keep all firms in the North, the choice of Southern tax rate is irrelevant. However,if the North sets its tax factor such that T < Tfr, then the South may be tempted to impose apositive corporate tax and this will put the two governments into a situation of tax
competition.
Consider first the Southern government’s problem, taking the Northern tax rate as given. Tax
revenue in the South is:

(15)

aR

1

0



South tax Re venue  B  B a*1

(1  T *)dG[a ](1  s)B  B * (1  T *)a R

The core of international tax competition is the classic rate-versus-base trade-off; charging ahigher rate means losing some firms to the lower-tax location, but also means extracting more
revenue from the firms that remain. To capture this trade-off most directly, we assume thatgovernments choose taxes to maximise tax revenue. This simplifies the expressions since iteliminates considers that operate on welfare via relocation’s impact on relative price indices.
Note that in this model, tax has no distortionary impact beyond relocation. For example, in aclosed economy a tax rate of even as high 99% would have no impact on prices, employment
or investment since the capital stock is fixed and fully employed and each firm needs one andonly one unit of capital. Taxation here merely transfers profits to the government.

4.1. Nash Equilibrium of Tax Competition
When both countries charge positive taxes, the equilibrium range of firms that relocate to theNorth (as measured by a R ) is now affected by T and T*, the South’s tax factor, i.e. 1-t* wheret* is the Southern tax rate. Using the suitably modified location condition, a R is now( s 2  (1  s ))T * TaR .
(1   )[{(1  s )  s}T * {s  (1  s )}T )]Tax and heterogeneous firms

11

a R
a R
 0 and 0 . 9 These results are intuitively*
TT
obvious; a lower Northern tax rate lowers a R , i.e. it expands the range of Southern firms that
prefer the North. A lower Southern tax rate has the opposite effect on a R .

Differentiating the cut off, we get

a R 0 . 10 This means that as the North gets relatively
slarger, it attracts more firms for any given set of taxes.

As far as market size is concerned,

Using location condition and tax revenue functions, the Nash first order conditions are:(16)

 North tax revenue
 0 and
T
T*

(17)

 South tax revenue
 0.
T *
T

Loosely speaking, we can think of these as the tax ‘reaction functions’. With a good deal of
simplification, they can be written as:
T [T *] (18)( s  (1  s ) 3 )T *   2   (1   ) 2 (1   ) 2 (1  T * )(T *   )(1  s ) s(1  s ) (T  1)  s (T   )
3

*

*

T*

and
T * [T ] (19)((1  s )  s 3 )T   2   (1   ) 2 (1   ) 2 (1  T )(T   )(1  s ) ss 3 (T  1)  (1  s )(T   )T.

Note that the above reaction functions are not fully symmetric, because firms areheterogeneous and the South (small country) in our model attracts high productivity firms bytaxation, and vice versa.
To exclude the case of complex numbers, we assume T >  and T* > . To ensure finite(1  s ) 3  s*
andslopes, the denominators in (18) and (19) should not be zero, i.e. T (1  s ) 4  s(1  s )  s 3.
T
s 4  1  s

9For convenience sake, we define AR  a R .

AR  A  ( s 2  (1  s ))T * T ( s  (1  s ) )

0
T
A2





AR ( s 2  1  s ) A  ( s 2  (1  s ))T * T (1  s  s ) 0 , where
T *A2A  (1   )[{(1  s )  s}T * {s  (1  s )}T }]AR T * (  1) A  ( s 2  (1  s ))T * T (1   )(1   )(T  T * ) 0 . Note that T>T* froms
A2
Result 2.

10

Tax and heterogeneous firms

12

Subject to these regularity conditions, we can show that the reaction functions are upward
sloped, i.e. the tax rates are strategic complements (as expected) since 2 North Tax Re venue
T T *

 0 and 2 South Tax Re venue
T * T 0 (See Appendix 1).

Figure 4 graphs the two reaction curves. 11 The intersection of the two curves, marked ‘N’, isthe Nash equilibrium tax rate. Tax revenue curves on the reaction curves are concave as seenin Figure 4 since tax revenue is the objective of both governments.

It is easy to show numerically that the big North has higher taxes in the Nash equilibrium. To
illustrate this intuitive results, we can consider an extreme case of when the North is muchlarger than the South, namely when the North’s share of world expenditure and capital is in
the neighbourhood of unity.
When s is approximately unity the Nash first order conditions simplify to:(20)

T [T *] T *   2 *T  T *T * 

andT * [T ] T 3T   2T3 (T  1)

Solving, we have T  T * , which says that the North always levies a higher tax, but the gap
narrows as trade gets freer.
To summarise, we write:
Result 2: Tax rates are strategic complements. The big country always has higher tax
rates than the small country in equilibrium.
Figure 4: Tax Reaction Curves and Tax Revenue Curves.

11

The parameter values in Figure are σ=2, ρ=2, =0.75 and s=0.6.

Tax and heterogeneous firms

13

T*

Reaction curve (North)S

Reaction curve (South)
N
C



0



T

4.2. Trade costs and Tax competition
The fundamental trade off for firms in this model weighs the net benefit firms receive frombeing in the large market against the higher tax rate. The fundamental trade off facing
governments is the higher tax revenue they would receive by raising rates on firms that stay
put versus the loss of some additional firms. Since the degree of trade freeness affects the net
benefits of being in the large market, changes in  will alter the trade-off faced by firms andthus indirectly the trade off faced by governments. As a result, tighter integration of goods
market (i.e. d > 0) will alter Nash equilibrium tariffs.
Given the non-linearity in the model, it is not possible to link the Nash tariffs to  analytically,
but numerical simulation for a wide range of parameter values show that both tax rates fall(i.e. the tax factors rise) as trade gets freer. The results of numerical simulations are shown in
Figure 5. We see that rising freeness of trade leads to higher tax factors for both nations butthat the gap narrows as they rise. Translating this into tax rates, it means that tax rates fallwith tighter goods market integration. The small nation’s Nash tax rate is everywhere lower
than that in the large country, but the gap narrows as trade costs fall. In short, this model
predicts a classic race to the bottom that intensifies as goods markets become better integrated.

Tax and heterogeneous firms

14

T, T*
1

T*

T

s


1

Figure 5: Tax factors and freeness of trade

We have worked out the Stackelberg equilibrium in this model. The point ’S’ in Figure 4 isthe equilibrium. Not surprisingly, both countries’ tax rates as well as their tax revenues arehigher in the Stackelberg versus Nash outcomes, as expected since the tax rates are strategic
complements in the Nash game.

4.3. Tax Cooperation
Above mentioned tax competition might not be the sole case. In order to maximise tax
revenues, two Leviathan governments might collude. The possible combination of T and T*
are determined by the maximisation of the sum of tax revenue, i.e. the differentiation of
Northern tax revenue plus Southern tax revenue in terms of T and T*. In Figure 4, theequilibrium is ‘C’. Tax revenue curves are both below those of Nash and Stackelberg
equilibrium. Both tax rates can be going up (T and T* go down). Since tax rates arecollusively increasing, tax revenue rises in both countries.

4.4. Welfare Analysis—Welfare-lowering Tax Competition
Now we turn to whether tax competition by revenue maximising governments is socially
optimal. A well known result for the Martin-Rogers model that we are using is that full
agglomeration in the North is socially optimal when trade freeness is low enough to sustain
full agglomeration in the absence of a tax gap (Baldwin et al. 2003 chapter 15). Since tax
competition drives some firms to the South, we can intuitively understand that tax
competition is not socially optimal.
More formally, social welfare in the North and the South are:V  North tax revenue  capital income  labour total income  s 

s
ln 
 1

V *  South tax revenue  capital income  labour total income  (1  s ) 

1 s
ln *
 1

Tax and heterogeneous firms

15

where we have normalised the world population to unity so North and South populations are s
and 1-s just as the mass of varieties in firms are s and 1-s, respectively. Thus the global
welfare is:V  V *  Total tax revenue  Total capital income  Total labour income  1 


1





1
( s ln   (1  s) ln * )
 1

1
( s ln   (1  s) ln * ) 1Given the Dixit-Stiglitz competition and the fact that expenditure is fixed by quasi-linear
preferences, total expenditure is invariant to the spatial allocation of firms. This in turn meansthat the world total operating profit is constant. Finally, since corporate taxation is merely aredistribution between the firms and the government, the world total of private profits post-tax
and the tax revenue must also be constant. Consequently, global welfare depends only on ∆and ∆*, i.e. the impact of firm location affects the price indices (recall that P1- =  and asimilar expression holds for the Southern price index). Because ∆ is proportional to the
production of located firms and the North is larger (s>0.5), full agglomeration in the North
can maximise s ln   (1  s) ln * . It follows that full agglomeration in the North is socially
optimal for global welfare. Anything the drives the spatial distribution of firms away fromthis lowers global welfare.
Because the competition for firms leads some firms to choose the South when they would
have chosen the North had tax rates been equal, we can say that tax competition is welfare
lowering.

4.5. Implications for average productivity
When firms are heterogeneous in terms of their productivity, firm relocation has an impact ona nation’s average productivity. In our model, large firms are the most sensitive to tax rate
gaps and so the productivity effects of tax competition are likely to be important.
In particular, the Nash tax equilibrium involves a Northern rate that is higher than theSouthern rate. As a result, not all firms are in the North in the Nash equilibrium. Indeed, it is
the highest productivity firms that move to the South. Comparing this to the benchmark where
no firms have relocated, we see that tax competition enhances the average productivity in theSouth (although the South has few firms, all this firms have marginal costs below aR). The
productivity effects are zero sum, so it is clear that the North’s average productivity falls,
although it does have many more firms than it would with no firm-mobility at all. This result
may have some resonance with the European situation where low but far from zero tax-rate
peripheral countries such as Ireland and Nordic countries successfully attract highproductivity firms.

5. CONCLUSION
This paper studies corporate tax competition in an economic framework that allows for
agglomeration effects and heterogeneous firms. The addition of heterogeneous firms enriches
the analysis in two ways.
Our paper could be extended in many ways. For example, we could include infrastructure andthe provision of public goods produced from the tax revenue. In these cases, welfare andtransfer issues could be much more important than in our paper and would provide richer

Tax and heterogeneous firms

16

results. Also, we could involve full features of economic geography models such as backward
and forward linkages and circular causality, although the basic outcome on tax competition
not, we conjecture, be substantially modified.

Tax and heterogeneous firms

17

APPENDIX 1 Strategic Complement

Here, we show the strategic complement in tax rates between two countries.
 2 North Tax Re venue
T T *

 B  2 a R
 2 aRB *  2 a R 

*

 


(
1

T
)(
1

a
)

(
B


B
)(
1

T
)
0
R
*
a R TT * T T * a R TT

where
B
s
B *
1 s
 1
,

(
1


)
a

0

(1   )a R 1  0 and
R
2
2





a
a R
 a R   (1  a R )
 (a R  1  a R )
R





 aR
0
TT *
2This indicates that the North is subject to strategic complement in its tax with the South.
Note that Southern taxation is a mirror of the North’s and we can get the same result ofstrategic complement.
APPENDIX 2 The impact of trade liberalisation on taxation

We can differentiate T in terms of freeness of trade:



 



dT
( s  3(1  s ) 2 )T *  2  E ' C  ( s  (1  s ) 3 )T *   2  E C ' *

T
d
C2

where C  (1  s ) 3 (T *  1)  s (T *   ) C ' 

due to 4T *  3  2 

dC
 (1  s)(4 3T *  3 2 )  s  0
d

s
.
1 s

We define asE   (1   ) 2 (1   ) 2 (1  T * )(T *   )(1  s) s
E' 


2
2
*
*
2
*
*
1  (1   ) (1   ) (1  T )(T   )(1  s) s  2 (1   )(1   ) (1  T )(T   )(1  s ) s dEd 2 E   2 (1   ) 2 (1   )(1  T * )(T *   )(1  s ) s   (1   ) 2 (1   ) 2 (1  T * )(1  s) s

1(1   ) 2 (1   ) 2 (1  T * )(T *  2 )(1  s ) s  4 2 (1   )(1   )(1  T * )(T *   )(1  s ) s
2E

If a (necessary) condition,(s  3(1  s) )T  2  E C  (s  (1  s) )T    E C  0 holds, dT
 0 is always
d
2

*

'

3

*

2

'

satisfied.
At extreme, when s=1, due to (T *   ) 2  0 ,dT
 0 always hold.
dSimilarly, we can differentiate T* in terms of freeness of trade.

Tax and heterogeneous firms

18



 



(1  s  3s 2 )T  2  F ' G  ((1  s )  s 3 )T   2  F G '
dT *

T
d
G2

where G  s 3 (T  1)  (1  s )(T   ) G ' dG
 s (4 3T  3 2 )  (1  s )dF   (1   ) 2 (1   ) 2 (1  T )(T   )(1  s ) s2
22
1  (1   ) (1   ) (1  T )(T   )(1  s) s  2 (1   )(1   ) (1  T )(T   )(1  s) s 
dF
F 


d 2 F   2 (1   ) 2 (1   )(1  T )(T   )(1  s ) s   (1   ) 2 (1   ) 2 (1  T )(1  s ) s

'





1
(1   ) 2 (1   ) 2 (1  T )(T  2 )(1  s) s  4 2 (1   )(1   )(1  T )(T   )(1  s ) s
2F



 




If a (necessary) condition, (1  s  3s 2 )T  2  F ' G  ((1  s )  s 3 )T   2  F G ' >0 holds,*dT
 0 is always satisfied.
d









At extreme, when s=1, 3 2T  2 (T  1)  (1   2 )T   (4T  3)  0 and thus

dT
0
d

always holds.

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