former case but not in the latter. Finally, it is shown that free entry in the location market calls for some regulation because of the excessive number of competing regions that would prevail in equilibrium. By the same token, Ben Zissimos, Myrna and Wooders (2006) argue that, because governments are able to relax tax competition through public good differentiation, traditionally high-tax countries can continue to set taxes at a relatively high rate even as markets have become more integrated. The key assumption is that firms vary in the extent to which public good provision reduces their costs. The authors show that Leviathan (i.e., revenue-maximizing) governments are therefore able to use this fact to relax tax competition, thus reducing efficiency. When firms can ‘vote with their feet’ tax competition leads firms to locate in ‘too many’ jurisdictions (for a closely-related model where regions compete in taxes and investment under fiscal equalization, see Hindricks, Peralta and Weber 2008).

Jayet and Paty (2006) go one step further in giving an explanation for the evidence that business area and industrial premises are often under-occupied or empty, i.e., over-provided. The authors propose a model where local jurisdictions must engage a development cost before competing for hosting a firm with uncertain preferences among possible sites. They first show that even an optimizing central planner managing all jurisdictions would develop more sites than there are plants to host because by doing so, he diversifies his supply and has a higher probability of hosting the firm. Then they show that, if every jurisdiction is managed by a local government, there are more developed sites than with the central planner, which implies excess supply. The outcome is analogous to overentry of firms on a market of diversified products, a point ignored for long in the literature of tax competition.

# _1.4. Economic Integration and Fiscal Competition: A Bell-shaped Relation?_

The existence of increasing returns of scale and of monopolistic competition corresponds to an agglomeration force which makes the idea of mobile factors marginally reacting to slight changes in tax rates illusory.<sup>11</sup> Inertia resulting from agglomeration forces implies a situation where fiscal competition does not necessarily lead to tax rates which are “too low” (as it is the case in non-increasing to scale returns models), since the mobile factor is concentrated and produces a taxable rent (see Baldwin and Krugman 2004). Furthermore, recent literature shows that agglomeration rent is bell-shaped in trade openness: economic integration, characterised by the diminution of transportation costs at first reduces the intensity of fiscal competition then increases it later on. Agglomeration effects—and thus the taxable rent—are the highest for intermediate transportation costs, in other words, for costs that are sufficiently low to make agglomeration happen and sufficiently high for spatial concentration to be a necessity.<sup>12</sup> The consequences for tax competition are _(i)_ that the equilibrium tax gap is also bell-shaped. Starting from a low level of openness and making trade freer first increases the tax gap, but then decreases it; _(ii)_ that core countries can engage in a “limit tax” game in which they set a tax rate sufficiently low to make the periphery countries abandon the idea of trying to attract the core (Baldwin and Krugman 2004). Gilbert, Lahrèche-Révil, Madiès and Mayer (2005) run an econometric study of the bell shaped relationship between economic integration and the tax gap between countries in order to determine a threshold of openness

> 11 See Ludema & Wooton (1998) Kind et al (1998), Andersson & Forslid (2003), Forslid & Ottaviano (2003). 12 Baldwin and Krugman (2004) present data to show that corporate tax rates in core countries (France, Germany, Italy and Benelux) have always been higher than tax rates in the poorer periphery countries (Ireland, Greece, Spain and Portugal). Data on the effective average tax rate developed by Devereux and Griffith (2003) appears to confirm Baldwin and Krugman’s assertions. In 2003 the average tax rate in the periphery was significantly below that in the core, at 23 percent compared to 31 percent respectively.

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