## _II.3.  Do We Observe Strategic Behavior and Fiscal Mimicking in Developing Countries?_

<mark>Most empirical studies presented here conclude that FDI inflows in developing countries are sensitive, to various degrees, to corporate income taxation and fiscal incentives. However, this does not mean that governments are strategically engaged in tax competition. Nor does it mean that governments mimic each other when choosing their fiscal policy as the yardstick competition literature may suggest. This is important since fiscal mimicking is likely to result in a prisoner’s dilemma situation which is harmful for competing countries. The most common way to check whether public authorities behave strategically with each other is to estimate fiscal reaction functions (see box 4). Besley, Griffith and Klemm (2001); Devereux, Lockwood and Redoano (2002) and Alsthuler and Goodspeed (2004) are more or less the only papers estimating an empirical model of strategic interactions in tax rates and public expenditure using large EU or OECD country datasets (though, as we will see below, there is a large number of papers dealing with tax interactions between local governments in the OECD). Redoano (2007) using annual data on Western Europe over 1970-1999 shows that (</mark> _<mark>i</mark>_ <mark>) the slope of the reaction function with respect to corporate income tax rates is positive and significant. Tax competition takes place in Europe with respect to big leading countries. (</mark> _<mark>ii</mark>_ <mark>) The same holds for personal income. However the explanation of tax interactions is different as there is no empirical evidence in Europe of tax-induced mobility (except for wealthy people who can enjoy special tax regimes). (</mark> _<mark>iii</mark>_ <mark>) Governments behave strategically mainly with respect to those expenditures which are more directly comparable such as education spending.</mark> <mark>This methodology has never been so far applied to developing countries because of lack of data. An exception is the paper by Klemm and van Parys (2009) which addresses two empirical questions about corporate income tax rates (CIT) and tax incentives: Are CIT and tax incentives used as tools of tax competition, and how effective are incentives in attracting investment? They use a new dataset of tax incentives in over 40 Latin American, Caribbean and African countries for 1985–2004. Using spatial econometrics techniques for panel data (spatial lag model) they find that there are strategic interactions in tax holidays as well as well-known interactions over the corporate income tax rate (however, Klemm and van Parys do not find evidence for interactions over investment allowances and tax credits). They also find evidence that lower corporate income tax rates and longer tax holidays are effective in attracting FDI (which is consistent with related studies presented above) but not in boosting gross private fixed capital formation or economic growth.</mark>

# **III.    Competition among Local Governments in Developing Countries**

<mark>There is a rich tradition of econometric research dealing with fiscal interactions among subnational governments in OECD countries. Most of these studies have established the importance of spatial interactions between local governments in these countries (see Ladd 1992; Besley and Case 1995; Rork 2003 for the United States; Heyndels and Vuchelen 1998 and Vermeir and Heyndels 2006 for Belgium; Buettner 2001 for Germany; Feld and Kirchgässner 2001 for Switzerland; Bordignon, Cerniglia and Revelli 2002 for Italy; Revelli 2002 for the United Kingdom; Solé Ollé (2003) and Bosch and Solé-Ollé 2007 for Spain; Allers and Elhorst 2005 for the Netherlands and Feld, Josselin and Rocaboy 2003 and Foucault, Madiès and Paty 2009 for France). However, most of these papers fail to identify empirically the reason why such interactions take place. It is well known that different theoretical hypotheses (tax competition; yardstick competition and public expenditure</mark> 20