The Ford motor company returned to Philippines in 1998 after an absence of 15 years, agreeing to build a USD 100 million assembly plant. It was reported to have won “concessions setting new standards for generous investment incentives”, following intensive lobbying. Soon afterwards, Chrysler and General Motors made it known that they were keen to return, if assured of obtaining similar concessions.

Within days of Philips concluding an agreement (in April 2000) with the Czech government, under which it was to receive tax incentives for establishing a television manufacturing plant, two rival producers—Matsushita and Tyco—negotiated similar concessions.

In 1999, Romania introduced special tax incentives for large investments that met certain conditions: The legislation was commonly known as the “Renault Act”, since the qualifying conditions were obviously tailored to accommodate the planned acquisition by Renault of a major share in the Dacia motor company. At around the same time, other tax incentives were being eliminated. All these examples are from Easson (2004).

_1.1. Fiscal Competition and Business Taxation: “Race to the Bottom” versus “Taming the Leviathan”_

# **The Basic Model of Tax Competition**

The basic model (which also addresses issues of competition over public inputs and public infrastructure) comes from the public finance and fiscal federalism literature. The theoretical foundations of numerous papers including Wildasin (2005) and Madiès, Paty and Rocaboy (2004) are the pioneer works by Zodrow and Mieszkowsky (1986), Wildasin (1991) and Hoyt (1991) (see Wilson 1999).<sup>3</sup> Public decision-makers are assumed to be benevolent in the sense that their objective is to maximise the welfare of their own citizens. Households are assumed to be immobile and consume both a private good and a regional public good. The latter is financed by a sourcebased tax on capital. Since capital is assumed to be perfectly mobile across regions, when a given government raises its tax rate, net return on capital located there falls and capital chooses to relocate. Marginal productivity of capital within the jurisdiction of departure increases, while marginal productivity of capital in the host jurisdiction decreases. Capital flows carry on until the net return on capital becomes identical everywhere.

Tax competition is thus modelled as a non-cooperative game where strategic variables are tax rates. The main result is that, at the Nash equilibrium, tax rate are too low and public goods are under-provided. In the case where the government can also tax labour, source-based tax on capital tends to zero at equilibrium leading to the so-called “race to the bottom.” Note that Razin and Sadka (1991) show that perfect international capital mobility can lead to a zero taxation of capital earnings.<sup>4</sup> This inefficiency results from the fact that each jurisdiction sees capital flight driven by a tax increase as a cost and does not consider the positive fiscal externality generated for other jurisdictions. Consequently, competing jurisdictions perceive

> 3 Wildasin (2005) underlines the importance of modeling tax competition in a dynamic setting and addressing consistency issue of tax policies.

> 4 For a survey on international tax competition and coordination, see for instance Fuest, Hubert and Mintz (2005) and Vondra (2006).

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