Country Size and Comp etition for Foreign

Direct Investment

Andreas Hauer and Ian Wooton

University of Konstanz and University of Glasgow and CEPR

February

Andreas Hauer Department of Economics and Statistics PO Box D Uni

versity of Konstanz D Konstanz Germany telephone fax

email AndreasHauerunikonstanzde

Ian Wo oton Department of Economics Adam Smith Building University of Glasgow

Glasgow G RT Scotland UK telephone fax

email IanWo otonso csciglaacuk

Pap er presented at workshops in Cop enhagen Konstanz Mannheim and at the Institute

for Fiscal Studies in London We wish to thank Stephen Bond Michael Devereux Harry

Grub ert Martin Hellwig Frank Hettich Mick Keen Sa jal Lahiri Jim Markusen Jurgen

Meckl Benny Moldovanu Sren Nielsen HansJurgen Ramser Peter Srensen and Kon

rad Stahl for helpful comments and suggestions This pap er was started while Wo oton was

a visiting professor at the University of Konstanz and further develop ed during Hauers

stayatEPRU of the Cop enhagen Business Scho ol The authors want to thank the two

institutions for the hospitality they received

Abstract

We analyze tax comp etition b etween two countries of unequal size

trying to attract a foreignowned monop olist When regional govern

ments have only a lumpsum prot tax subsidy at their disp osal

but face exogenous and identical transp ort costs for imp orts then

b oth countries will always oer to subsidize the rm Furthermore

the maximum subsidy is greater in the larger region However if

countries are given an additional instrument of either a tari or a

then the larger country will no longer underbid its

smaller rival and its b est oer mayinvolve a p ositive prot tax In

b oth cases the equilibrium outcome is that the rm lo cates in the

larger market paying a prot tax that is increasing in the relative size

of this market and which is made greater when the tari consumption

tax instrument is p ermitted

JEL classication numb ers F F F F H H

Keywords tax comp etition economic integration foreign direct in

vestment regional lo cation

Intro duction

When a rm cho oses to b ecome a multinational enterprise and establish a

foreign pro duction plant it seldom builds a factory to service only the do

mestic market of the country in whichitisinvesting Instead it establishes a

base from which it supplies consumers in surrounding countries This foreign

direct investment FDI mayhave b een triggered by eorts at increasing the

level of integration b etween countries in the region as have recently b een

taken by regional economic groupings such as the Europ ean Union EU

NAFTA and the ASEAN countries Thus for example the EUs Single

Market Initiative has reduced the remaining barriers to b etween mem

b er states and has raised the level of comp etition within the region see Smith

and Venables Even if external trade barriers are unchanged these

p olicies of reducing intraregional trade costs put suppliers from outwith the

region at a disadvantage for example transforming the EU into Fortress

Europ e The foreign rms may resp ond by setting up pro duction within

the region in order to avoid the external trade barriers and avail themselves

of access to the single market Consequently the tarijumping incentiveto

build a branch plant is increased when trade barriers within the region are

lowered see for example Norman and Motta

In this pap er weinvestigate what inuences a foreignowned rm in its

choice of country in whichtoinvest once it has opted for foreign direct in

vestment rather than exp orting from its home base In particular we fo cus

estment in a region in which p opulation is asymmetri on foreign direct inv

cally distributed b etween countries and there are some remaining barriers to

intraregional trade though these are lower than on trade with countries out

side the region The existence of trade costs creates a home market bias

familiar from the new trade theory eg Krugman whichinteracts

with tax p olicy as governments attempt to attract the foreign rm by oering

investment incentives Recent empirical work has shown that b oth market

size and the eective on capital are imp ortant factors in inuencing

multinational rms choices of countries in whichtoinvest Devereux and

Freeman Devereux and Grith Grub ert and Mutti

These empirically relevant determinants of FDI lead us to drawontwo

elds whichhave traditionally b een largely separated in the literature the

new trade theory on the one hand and the public nance related literature on

international tax comp etition on the other In the trade literature muchof

the traditional analysis has examined FDI in a generalequilibrium comp et

itive setting Thus Bhagwati and Brecher establish that international

trade can b e harmful for a nation in which some of the pro ductive resources

are foreign owned More recentwork has fo cused on imp erfectly comp et

itivemarkets and has intro duced transp ort costs as a mo del element that

plays an imp ortant role for the decision whether to exp ort or pro duce lo

cally Horstman and Markusen show that dierenttyp es of equilibria

will arise in a tworm twocountry setting dep ending on the relative im

p ortance of unit transp ort costs vs xed costs at the plant and at the rm

level Trade costs also play a critical role in the economic geography mo del

of Krugman in which the lo cations of monop olistically comp etitive

rms are endogenously determined by the migration decisions of manufac

turing workers In this mo del trade costs encourage agglomeration as they

make foreignpro duced go o ds relatively more exp ensive than go o ds pro duced

domestically and hence aect the real wage of workers

Several very recent pap ers have incorp orated tax comp etition in a frame

work of imp erfectly comp etitive markets Markusen Morey and Olewiler

study a mo del where governments comp ete through environmental

when pro duction activity causes lo cal p ollution and a multinational

ts in one b oth or none of the comp eting regions rm may op erate plan

Environmental tax p olicy is also studied in Rauscher who compares

nonco op erative and co op erative outcomes when countries comp ete for the

lo cation of a foreignowned monop olist Janeba combines oligop olistic

b ehaviour and international mobility of rms and shows that a secondb est

ecient zerotax equilibrium results in this case in contrast to the subsidy

race that o ccurs in the case where rms cannot relo cate pro duction Walz

and Wellisch ask whether the decentralized provision of lo cal public

inputs is ecient in a setting where the lo cal governments comp ete for the

lo cation of an oligop olistic rm Lahiri and Ono consider a small host

country that optimally deploys prot taxes and lo cal content rules when a

variable number of identical foreign and domestic rms comp ete in its do

mestic market Finally Ludema and Wo oton extend the Krugman

mo del to allow for tax comp etition b etween governments as eachcountry

tries to induce workers to migrate by altering its taxes on lab our

On the other hand most contributions on tax comp etition in the public

nance tradition have adopted a framework of p erfect comp etition but have

intro duced various sources of asymmetries b etween countries and have stud

ied the interaction b etween dierent tax instruments One branch in this

literature which is directly relevant for the presentwork fo cuses on asym

metric tax comp etition b etween countries of dierent size Bucovetsky

Wilson Kanbur and Keen Trandel A general result

from this literature is that the small country cho oses the lower tax rate and

achieves the higher p ercapita utility level in the Nash equilibrium relativeto

the large country Another strand in this literature considers the optimal mix

of source and residencebased capital taxation when there is crosshauling of

foreign direct investment and rents from xed factors cannot b e fully taxed

y a separate instrument Mintz and Tulkens Huizinga and Nielsen b

A still dierent set of pap ers with links to the present analysis an

alyzes subsidy comp etition for interregionally mobile rms In Blackand

Hoyt two cities are trying to attract rms and b enet from scale

economies in the provision of public go o ds and services Another reason for

subsidy payments is analyzed in Haaparanta where the comp eting

countries face dierentlevels of exogenously xed wages However none of

these pap ers incorp orates trade costs b etween the comp eting regions Hence

dierences in market size if they exist do not aect the lo cation decision

of the multijurisdictional rm

The present pap er combines the trade cost element from the new trade

literature with the existence of dierences in country size and multiple tax

instruments We argue from the empirical evidence quoted ab ove that this is

a relevant setting for studying tax comp etition for foreign direct investment

pro ducing results that dier critically from those established in the previous

literature Our analysis considers two dierent settings Initiallywe assume

that there are exogenously determined trade costs which are incurred when

go o ds are shipp ed b etween countries In this case the only instrumentavail

able to eachgovernment is the ability to tax or subsidize the op erations of a

rm that invests within its national frontiers We nd that the existence of

trade costs reverses the answer to the question whether the large or the small

country wins the comp etition for internationally mobile capital Later we

shall replace the trade costs by a second p olicy instrumentwhich can either

be interpreted as a tari or closer to the Europ ean setting as a consump

tion tax Weshow that in the presence of this second instrument the large

country will not only b e able to attract the rm it will also quite likely b e

able to imp ose a p ositive prot tax in the lo cational equilibrium

Throughout our analysis wekeep the pro duction structure as simple

as p ossible and fo cus on a monop olist which lo cates in only one of the two

regional markets Furthermore we take a partialequilibrium view of FDI and

ignore the consequences of the investment for factor earnings The optimal

tax p olicy in each region is determined by the gains and losses in the form

of tax revenues and consumer surplus that arise from having a domestic

factory rather than imp orting the go o d from abroad

The remainder of this pap er is organized as follows section describ es

the basic mo del which applies to b oth p olicy settings discussed thereafter

Section analyzes prot tax comp etition b etween the twogovernments when

aste Section trade costs are exogenous and represent a source of pure w

then turns to the case where trade costs take the form of an additional p olicy

instrument tari or consumption tax and provide a source of tax revenues

Section compares our results with those established in previous contribu

tions on interregional capital tax comp etition and section concludes

The Mo del

The households

Consider a mo del of a region comp osed of two countries lab elled A and B

Two go o ds are consumed in each country the numeraire go o d Z is pro duced

by comp etitive rms while go o d X is pro duced by a monop olist intenton

establishing pro duction facilities in one of the countries to service the regional

market Preferences in b oth countries are identical and equal to



u x x z i fA B g

i i i

i

where u is the utility of a representative household and x and z are its

i i i

consumption of go o ds X and Z resp ectively We assume that there is a

single household in country B and n identical households in country A

Therefore without loss of generality country A is the large marketplace for

good X in the region

Each household supplies one unit of lab our for which it receives a wage

of w in units of the numeraire go o d Z Furthermore we assume that in

each country all revenues that the government obtains from taxation are

distributed equally and in a lumpsum fashion across the p opulation If these

revenues are negative then our treatment implies symmetrically that each

government can imp ose lumpsum taxes on its p opulation Denoting total

tax revenues by T the budget constraints facing a representative household

i

in each region are

T

A

z q x w T z q x w

A A A B B B B

n

where q is the consumer price of go o d X in country i Maximization of

i

sub ject to the budget constraint yields the representative households

The quadratic utility functions in are frequently used in the new trade literature

b ecause they oer a simple way to compare welfare levels in discrete choice problems as

the one studied here see for example Markusen and Horstman and Markusen

Morey and Olewiler As we will p oint out however some of our results do not

dep end on this sp ecic utility structure

inverse demand for go o d X

x q i fA B g

i i

Note that the individuals tax receipts or payments do not enter the demand

function for go o d X since at the margin income changes aect only the

demand for the numeraire go o d Z Aggregating over households in country

A and rewriting yields the market demand curves for the twocountries

n q

A

X nx

A A

q

B

X x

B B

Hence the market demand curve of the small country B is steep er than the

demand curve of country A This has immediate implications for the optimal

price p olicy of the monop olist to whichwenow turn

The rm

We assume that the rm cannot price discriminate b etween markets and con

sequently charges the same pro ducer price p the consumer price net of trade

costs irresp ective of the country in which the go o d is sold This assumption

can b e motivated either by the existence of a common comp etition p olicy as

in the EU Smith and Venables or byinternational antidumping reg

ulations which prohibit price discrimination b etween markets Haaland and

Wo oton The consumer price of go o d X in country i will however

dep end on whether it is lo cally pro duced or imp orted from the other coun



try in the region as imp orts incur a trade cost of p er unit We therefore

i

have to distinguish b etween the cases of the monop olist setting up in country

j

A and its establishing pro duction facilities in country B Let q denote the

i



In section the price wedge b etween markets will take the form of a tari or a

consumption tax Go o d Z is assumed to b e freely traded at all times that is without

trade costs or taris

consumer price of go o d X in country i when it is manufactured in country

j This leads to the following price relations

A A

q p q p for FDI in country A

A A B

A B

B B

p for FDI in country B p q q

B B A

B A

We assume a very simple pro duction structure There is a onetime xed

cost of setting up pro duction in either country and this is suciently large

to ensure that the rm will not cho ose to op erate plants in b oth countries

Lab our is the single factor of pro duction and the pro duction technology has

constant returns to scale The input of one unit of lab our is necessary for

the pro duction of one unit of go o d X so that marginal cost is equal to the

wage rate w In order to fo cus on dierences in country size we assume the

wage rate to b e the same in b oth countries

The host country can levy a lumpsum tax subsidy if negative on the

rms prots if it sets up op erations within its frontiers In a stylized form

this tax instrument incorp orates b oth direct investment subsidies paid to

rms and cash ow taxes on pure prots Let the tax set by host country i

be t Net prots of a rm based in country i will b e its prots from sales in

i



b oth countries less this tax Since X are the rms aggregate sales in each

i

country this gives

h i

A A

p w X q X q t for FDI in country A

A A A B A

A B

h i

B B

p w X q X q t for FDI in country B

B B A B B

A B

Substituting the demand equations and the consumer price denitions



Our treatment implies that the source principle of taxation is relevant for foreign

direct investment The home countries of multinational enterprises typically allowthe

rm to defer taxes on the prots of foreign subsidiaries until these prots are repatriated

Furthermore they generally limit the that the multinational can claim for the

taxes paid in the host country to the residence countrys own tax rate on the same income

Both of these practices imply that corp orate taxation indeed conforms quite closely to the

source principle cf for example Tanzi and Bovenb erg and the references cited

there

yields

p w

A

p n t

A A B A

p w

B

p n n t

B B A B

The optimal price p olicy of the rm will generally dep end up on its choice of

lo cation Dierentiating each of the prot expressions in and solving for

the optimal prices yields

B

p w for FDI in country A

A

n

n

A

p w for FDI in country B

B

n

Note that prices are indep endent of the lumpsum taxes on establishment set

by each country but do dep end on the trade cost If trade costs are the same

in b oth directions then the rm will charge a lower pro ducer price

A B

if it settles in the smaller country B than if it were to establish in country

A This result is obtained b ecause the ma jority of trade costs are avoided by

the rm pro ducing in its larger market Hence there is an incentive for the

rm to lo cate in the large market the home market bias familiar from the

new trade literature if wages and tax rates are equal in the two countries

Inserting into gives the maximum prots attainable from lo cating

in a particular country



n w

B

t

A A

n



n w n

A

t

B B

n

The rm will b e indierentbetween lo cating in country A or country B if

We dene by t t the amountby which country As

A B A B

tax can exceed that of country B and still leave the rm indierentbetween

pro duction lo cations This tax premium that the rm is willing to pay for

lo cating in country A is given by

n w n n

A B A B

n

Equation determines the lo cation decision of the rm for anygiven set

of tax rates t and transp ort costs In the following we will consider two

i i

dierent cases In section transp ort costs are exogenous and assumed to b e

equal across countries so that tax comp etition b etween national governments

o ccurs solely with resp ect to the lumpsum tax t In section the transp ort

i

costs are reinterpreted as taris or equivalently in the present framework

consumption taxes on go o d X Hence governments havetwo instruments

at their disp osal and we will analyze how this aects the outcome of tax

comp etition b etween the large and the small region

Tax Comp etition with Symmetric Trade Costs

In this section we assume that trade costs transp ortation costs are exoge

nous and equal to p er unit no matter in which direction go o d X is shipp ed

In this case equation simplies to

n w

This expression is zero when countries are of equal size n the mo del

is then completely symmetric and the rm has no preferences for lo cating in

either countryFor n however m ust b e unambiguously p ositive since

w gives the average of the gross prots earned from selling the

rst unit of output in the two national markets Thus country A can set a

higher tax rate than country B yet still attract the rm We note that this

result is not conned to the case of linear demand functions but it will hold

for anydownwardsloping market demand curve as long as preferences in the

twocountries are identical Furthermore dierentiating with resp ect to

gives

d n w

d

which is p ositive for p ositive sales in the imp orting region Hence the tax

premium that the rm is willing to pay for lo cating in countryAislarger

the greater are the p erunit trade costs

Eachgovernment compares the welfare of its representative household

when the country is host to the rm to that when it is not The income

of the representative household in country A arises from the earnings from

employment together with its share of any tax revenues collected and re

distributed lumpsum by the government Thus the households budget

constraintincountry A cf eq is

t

A

A

for FDI in country A q x z w

A A

A

n

B

x z w for FDI in country B q

A A

A

Substituting together with the demand function the consumer price

denitions and the rms protmaximizing pro ducer prices into the

utility function yields for country A



t n w

A

A

u w for FDI in country A

A

n n



n w n

B

u w for FDI in country B

A

n

The government of country A and its citizens will b e indierentbetween

A B

b eing the host and imp orting the go o d when u u This equality de

A A

termines the minimal tax rate or the maximum subsidy that country A is

willing to oer in order to attract the rm Solving for this tax rate which

is denoted by t gives

A

n n w

t

A

n

Thus countryAwould b e prepared to subsidize the rm in order to induce

it to lo cate within its b orders As home pro duction reduces the consumer

price for go o d X in country A relative to imp orting a lumpsum subsidy

can b e paid to the rm that still leaves consumers in country A equally well

A

o than if they had to imp ort go o d X from country B Note that q the

A

B

the consumer price consumer price with home pro duction is less than q

A

with imp orting even though the rms pro ducer price will b e higher if it

lo cates in country A cf eq However the dierence in pro ducer prices

will b e less than the trade cost p er unit this follows from the fact that a

monop olist will not nd it optimal to fully shift a cost increase into consumer



prices if demand functions are linear

Similar calculations can b e carried out for country B The household

budget constraint for this country is

A

q x z w forFDIincountry A

B B

B

B

x z w t forFDIincountry B q

B B B

B

Substituting along with and into the utility function

gives for country B



n w n

A

u w for FDI in country A

B

n



n w n

B

w t for FDI in country B u

B

B

n

A B

Setting u u determines the tax rate at which country B is indierent

B B

between having go o d X pro duced at home or abroad

n w

t

B

n

Thus country B is also ready to oer a subsidy in order to get the foreign

direct investmentandsave transp ortation costs To see which of the two

countries oers the higher subsidy we compare the tax rates in and

and dene t t to b e the dierence b etween the prot tax rates at

A B

which b oth countries would b e indierentbetween b eing host and imp orter

This gives



n w

n



Note that the precise level but not the sign of the tax rate t is aected byour

A

assumption that the government of country A can levy lumpsum taxes from its residents

in order to nance a subsidy to the rm If distortive taxes had to b e used instead then

t would b e smaller in absolute value but it would still b e negative

A

Hence country A is always prepared to oer a bigger subsidy to the rm than

would b e oered bycountry B This result seems surprising at rst glance

since the b enets of home pro duction in the form of reduced consumer prices

are higher in country B By the argument made earlier this last observation

follows b ecause country B not only saves transp ort costs if it is able to attract

the rm but the pro ducer price eq will also b e lower in this case

However the per capita costs of the subsidy are smaller in country A since

there are a larger numb er of residents who share in the aggregate tax burden

For the utility sp ecication chosen here the latter eect dominates the former



and country A oers the higher subsidy b ecause of this clubgo o d eect

The next step is to bring together equations and whichsum

marize the conditions under which the rm on the one hand and the two

governments on the other are indierentbetween the two alternative out

comes From weknow that the rm is willing to accept a higher tax level

in country A and still lo cate there whereas states that the maximum

subsidy country A would b e willing to oer is higher than that of country B

Hence it is immediately clear in this setting of exogenous and equal transp ort

costs that the rm will settle in the large country A

However to attract the rm country A need not actually pay the subsidy

t it suces to slightly improve from the p ersp ective of the rm on the b est

A



oer of country B in order to get the investment Country As

rate is thus t t Given country Bs b est oer this is the maximum

A B

tax that country A can charge while keeping the rm indierentbetween



lo cations Taking country Bs b est oer from and substituting into



We note that with more general utility and demand functions it may not b e p ossible

to unambiguously sign the term in eq However as the following discussion will

show this is also not required for our main argument



This is a standard result from the theory of auctions the winner of the auction pays

a price equal to the valuation of his last remaining rival and earns some economic rent

See eg McAfee and McMillan



Note that this always implies p ositive net prots to the rm in equilibrium since gross

prots are p ositiveincountry B eq and country Bs b est oer involves a subsidy to

the rm

yields



n n w

t

A

n

Aslightly lower tax higher subsidy than given in will guarantee that

the rm sets up in country A From the quadratic equation in the numerator

of the equation one can establish that country A will actually b e able to

charge a positive prot tax if its market is suciently large relative to that

of country B The critical value at which country As optimal tax rate turns

p ositiveis n Dierentiating t with resp ect to relativemarket size

A

gives

dt n n w

A



dn n

and so the optimal tax charged by country A is increasing with the relative

size of the country

One caveat to our analysis is that the rm always has the outside option of

not lo cating in the region at all but rather to exp ort to b oth countries A and

B from its home base Thus there may b e an additional limit to the taxing

power of the large country A which is not mo delled in the present pap er

The exp orting vs FDI decision has b een extensively discussed in several

recent studies eg Markusen and Horstman Markusen Moley and

Olewiler Norman and Motta In particular Norman and Motta

haveshown that continuing integration within a union makes lo cal

pro duction in one of the union countries more attractive b ecause it reduces

the costs of exp orting from this country to its union partners relative to the

costs of exp orting from a third nonmemb er state Hence as long as extra

regional trade costs are suciently high the rm will haveanincentiveto

directly invest in country A at all relevant levels of t oered by this country

A

Tax Comp etition with Two Instruments

Wenow assume that the wedge b etween the consumer prices in the two

markets arises not from an exogenous trade cost but from a trade tax chosen

optimally byeachofthetwo countries For simplicitywe will generally refer

to this trade tax as a tari but we emphasize that the additional instrument

can equivalently b e seen as a consumption tax The equivalence is strict

in our mo del b ecause there is no domestic pro duction of go o d X in the

imp orting country The interpretation of the trade tax as a consumption tax

is of course esp ecially imp ortant in a EU context As is argued for example

in Keen there is evidence that nationally chosen levels of sp ecic

commo dity taxation in the EU include a strategic element to discriminate

against imp orts and thus act as a partial substitute for imp ort taris

To incorp orate the additional p olicy instrument wemust rst mo dify the

budget constraints to takeinto account that taris in contrast to trans



p ortation costs represent a source of revenues for the imp orting country

Hence the budget constraint for countryAisnow

t

A

A

for FDI in country A q x z w

A A

A

n

B

q x z w x for FDI in country B

A A A A

A

and similarly for country B

A

x z w x for FDI in country A q

B B B B

B

B

q x z w t for FDI in country B

B B B

B

Recall that due to our assumption of quasilinear preferences this change in

the representative individuals budget constraint has no eect on the market

demand functions for go o d X eq Furthermore the protmaximizing

price chosen by the rm in each particular lo cation is indep endent of the

source of the trade cost Hence the mo del presented in section is completely

unchanged when we replace exogenous transp ortation costs by endogenously



If the tax is interpreted as a consumption tax then this instrumentisalsoavailable to

the host countryHowever in our mo del the only reason for the host country to employ

the sp ecic commo dity tax is to indirectly tax the prots of the rm But this can b e done

directly with the prot tax t which do es not distort the consumers choice b etween go o ds

i

X and Z Hence in the optimum the host country will always cho ose not to employthe

commo dity tax and this is whywe can neglect this instrument from the outset

chosen taris Note however that equation which summarizes the con

ditions under which the rm is indierentbetween lo cations now dep ends

on b oth the taris and the prot tax rates chosen by the twogovernments

Governments again compare the utility of the representative consumer

in the situations where the monop olist lo cates at home or abroad Incorp o

rating the budget constraints and using and gives for

country A



n w t

B A

A

u w for FDI in country A

A

n n





n w n

A

B A

u w for FDI in country B

A

n

and for country B





n w

B

B A

w for FDI in country A u

B

n



n w n

A

B

u w t for FDI in country B

B

B

n

Comparing with the analogous expressions in the case of exogenous

transp ortation costs eqs and shows that the utility expressions are

unchanged for the host country except that they now dep end on the tari in

the other region rather than the exogenous transp ortation cost In contrast

the utility level for an imp orting region is changed through the additional

revenue collected from the tari

From eqs and we can determine the optimal tari that each

country will set when it fails to induce the rm to set up lo cal pro duction

facilities Thus the optimal tari for country A is determined from the second

equation in while country Bs optimal tari is obtained from the rst

In the imp orting regimes of the tari terms in the squared bracket are

p ositive whereas they were negative in and Hence tari revenue will enter the

imp orting countrys utilitylevel with a p ositive sign even though the last terms in the

imp orting regimes of and are negative

equation in Partial dierentiation with resp ect to yields

i

n n w

A

n n

n w

B

n n

Thus each country will set a p ositive tari if it imp orts go o d X Theintuition

underlying this result is a conventional terms of trade argument since the

tari reduces the pro ducer price chosen by the monop olist lo cated in the

other country eq Furthermore for n we can see that must

A

exceed thenumerator is larger but the denominator is smaller in the

B

optimal tari formula for country A Of course this is b ecause country A as

the larger country enjoys the greater monop oly p ower in trade

The optimal taris obtained ab ove can now b e substituted into the condi

tions under which b oth the rm and the governments are indierentbetween

alternative lo cation decisions Given that each country will optimally tax its

imp orts when it cannot attract the rm the prot tax dierential t t

A B

that leaves the rm indierentbetween the two lo cations is given by insert

ing into This gives after straightforward manipulations

 

h i

w n n

  

n n n n



where

n n n n

Hence the rm is again willing to pay a tax premium for lo cating in the

large market This premium is now due to two distinct factors if the rm

should lo cate in country B then a larger numb er of its customers face the

tari and the tari imp osed by country A is higher than the tari that

would b e chosen by country B While the rst of these two eects is the

direct analogue to the transp ortation cost analysis of the previous section

the second eect stems from the endogeneity of the trade cost comp onentin

the present setting Overall then the availability of the new tax instrument

tends to further strengthen the incentive for the rm to lo cate in the large

country A

To derive the taxes at whichgovernments would b e indierentbetween

imp orting the go o d and having lo cal pro duction we substitute into

This gives for country A





n w t

A

A

u for FDI in country A w

A

n n n

 

n w

B

w for FDI in country B u

A

n n

and analogously for country B



 

n w

A

u w for FDI in country A

B

n n





n w

B

u w t for FDI in country B

B

B

n n

Country A is indierentbetween b eing host and b eing imp orter when

A B

u u in This gives the minimum tax maximum subsidy that

A A

country A is willing to oer the monop olist

 

n n w

A

t

A

n n

where isgiven in and

  

n n n n

A

It is easily seen that is negative for small values of n but turns p ositive

A

as n increases with a critical value of n where country As b est oer

involves a prot tax of zero Hence in contrast to the case of exogenous

transp ortation costs country A will not generally oer a subsidy to attract

the rm The reason is that as n increases country A will set higher taris

on the imp ort of go o d X and b enet from reduced pro ducer prices forced by

its tari The existence of the second tax instrumentthus increases the bar

gaining p ower that country A has visavis the monop olist and will generally

enable country A to oer a less favourable tax treatment to the rm

Analogously country B is indierentbetween b eing host and b eing im

A B

p orter when u u in This gives country Bs b est oer to the rm

B B

 

n w

B

t

B

n n

where

  

n n n n

B

As in the previous section country B will thus oer a subsidy to the rm for

all values of n even though it can set a p ositive tari in the case that the

rm lo cates in country A This shows that it is only the relative monop oly

power in trade that aects the prot tax rates oered to the rm

Next we compare the b est oers made by countries A and B Forming

t t and substituting in from and gives

A B

 

h io n

w n n

 

n n n n



Comparing with the analogous expression in the case where trade costs

were exogenous and symmetric eq shows that country A now oers

fewer rather than more lo cation incentives to the rm relative to coun

try B This change in the relative tax levels arises b ecause country A now has

an improved alternative to lo cal pro duction If it has to imp ort it applies a

relatively high optimal tari and collects the tari revenues

When trade costs were exogenous countryAwas always willing to sub

sidize the rms investment more than was country B Given the preference

of the rm for the larger market this guaranteed that country A was able

to induce the rm to set up there With endogenous taris however coun

try A is less willing to subsidize foreign direct investment raising the ques

tion whether country A will still attract lo cal pro duction Thus wehave

to compare from and This gives after straightforward

manipulations

 

n

w n n



n n



io h

   

n n n n n

Since this dierence is unambiguously p ositive country A will still get the

rm even though it imp oses the higher prot tax Hence it is again the e

cient solution that prevails in equilibrium a smaller numb er of consumers

then faces a lower tari as compared to pro duction in country B These aggre

gate eciency gains can b e divided up b etween the rm and the government

of country A ensuring that the tax premium that the rm is willing to pay

for lo cating in country A exceeds the tax premium implied bycountry As

b est oer

In the following we assume again that country A is able to appropriate

the entire lo cational rentby oering a tax rate t that leaves the rm only

A

marginally b etter o than if it accepted the b est oer of country B Hence

t t and substituting in from and gives

A B

 

i h n

w n

   

n n n n n n t

A



o



n

B

where is given in Tointerpret let us rst consider the

B

b enchmark case where countries are of equal size For n the p ositive rst

term in the square bracket disapp ears and country A must oer a subsidy to

the rm to induce home pro duction For suciently small dierences in size

country As optimal prot tax rate will thus still b e negative even if it has

the additional tari instrument However as n increases the optimal tax

rate t grows more rapidly now than in the case of exogenous transp ortation

A

costs and turns p ositiveata value of n This compares with a

critical value of n in the case without taris Hence the existence of a

second tax instrument raises the likeliho o d that country A is able to c harge

a p ositive prot tax rate in the lo cational equilibrium

This eciency result is well known for auctions of the simple typ e mo delled here

McAfee and Mc Millan It is also emphasized in BlackandHoyt

Discussion of Results

This section compares the results of the present mo del with those derived

in the previous literature on capital tax comp etition In particular wewill

argue that intro ducing trade costs to a mo del of tax comp etition b etween two

countries of dierent size critically aects the results obtained and p oints to

an imp ortant dierence b etween the comp etition for nancial capital versus

the comp etition for foreign direct investment

The rst contrast with previous results concerns the sign of the prot tax

rate that is imp osed on the rm in the lo cational equilibrium Haaparanta

considers twocountries that dier b oth in their exogenously xed

wage rate creating unemployment and in country size There are no trade

costs in his mo del however Under these conditions it turns out that dier

ences in market size are inessential for the optimal tax p olicy Both countries

will always subsidize foreign direct investment in equilibrium in an attempt

to alleviate domestic unemployment An alternative reason for subsidy pay

ments to the rm is given in Black and Hoyt where the lab our market

is cleared but countries attempt to realize scale economies with resp ect to

the provision of public go o ds and services Black and Hoyt show that un

der these conditions the maximum bid of b oth countries always involves a

subsidy to the rm even if countries dier with resp ect to a nonlab our cost

comp onent

In contrast there is a distinct p ossibility in the present mo del that the

large country is able to extract a p ositive tax rate from the rm that lo

cates within its b orders In the presence of trade costs the dierence in

country size gives rise to a lo cationsp ecic rent that the rm can earn in

try and this in turn allows the large country to tax some of the large coun

these rents in equilibrium Moreover if the taris consumption tax instru

ment is added then even the best oer of the large country mayinvolvea

p ositive prot tax rate This links our pap er to contributions byMintz and

Tulkens and Huizinga and Nielsen where countries are small in

p erfectly comp etitive capital markets but lo cationsp ecic rents derive from

xed domestic factors In these mo dels p ositive taxes on internationally mo

bile capital serve as an indirect way of taxing rents which cannot b e fully

taxed by an indep endent instrument

The dierence b etween our mo del and those of Mintz and Tulkens

and Huizinga and Nielsen is that we link the source of the lo cational

rent directly to an observable country characteristic market size This

brings us to the second departure from the existing literature on capital tax

comp etition which concerns the question whether the large or the small

country wins the comp etition for mobile capital Bucovetsky and

Wilson haveshown that when two countries of dierent size but with

equal p er capita endowments comp ete for internationally mobile capital

then the small country faces the more elastic tax base and hence cho oses the

lower tax rate in the nonco op erative tax equilibrium As a consequence the

small region attracts a more than prop ortional share of mobile capital and

achieves a higher p ercapita utility level than the large region Wilson

Prop ositions and

In the present mo del the small country will also underbid the large coun

try if b oth countries have an additional trade tax at their disp osal section

In this case the lower monop oly p ower in trade induces the small country

to oer the higher subsidy to the rm even though the p ercapita costs of

a given aggregate subsidy are higher than in the large region The small

countrys higher elasticity of the domestic tax base and its reduced p otential

to use restrictive trade p olicies as a bargaining device towards the rm may

thus serve as complementary and mutually compatible explanations for the

empirical observation that small countries tend to havelower rates of capital

taxation

However in contrast to the earlier literature the large region wins the

comp etition for foreign direct investment in the present mo del in that it

attracts the foreign rm Furthermore the large country A will always have

the higher p er capita welfare level in the resulting lo cational equilibrium

The last result is easily established for b oth cases covered in our analysis by

B

noting that country As welfare if it is host cannot fall b elow the level of u

A

in eqs and and it will actually b e higher since country A do es not

B

have to oer the tax rate t to get the rm Since for n u is in turn

A

A

A

greater than u in and the p er capita utility level that country A

B

achieves in equilibrium must exceed the utility level obtained by country B

The critical dierence b etween the two approaches lies again in the exis

tence of trade costs which implies that p opulation size has two counteracting

eects in the present mo del The rst eect is that the large countrywillin

the second mo del with endogenous trade costs charge the higher prot tax

rate in equilibrium At the same time however there is a second eect of

country size since the existence of transp ort costs gives the rm an incentive

to lo cate in the larger market As our analysis has shown the second ef

fect will dominate in equilibrium and the large country is able to attract the

rm despite the higher tax that it charges When trade costs are excluded

however then only the rst of these two eects is present and capital always

lo cates in the lowtax region

Empirical evidence strongly suggests that market size is an imp ortant de

terminant for the lo cation of foreign direct investment in a particular country

Surveying the theoretical and empirical literature on the role of multinational

uch of foreign direct invest corp orations Cantwell concludes that m

ment since has b een lo cal marketoriented Similarly recent econometric

studies nd that the size of the host country has a p ositive and signicant

eect on the probability of a US multinational to invest in this country

this is true b oth in a Europ ean context Devereux and Grith and

worldwide Grub ert and Mutti Furthermore Grub ert and Mutti also

nd a statistically signicant and p ositive relationship b etween country size

and the eectiveaverage tax rate on capital indicating that larger countries

can aord higher tax rates

In the new trade literature it has b ecome common to distinguish sharply

between the mo delling of p ortfolio investments on the one hand and foreign

direct investment on the other Cantwell With resp ect to the latter

trade costs have b ecome a standard mo del element that allows to capture

the empirically conrmed role of country size in a simple wayIncontrast

mo dels of tax comp etition in the public nance tradition typically do not

consider trade costs so there is often no clear analytical distinction b etween

the twotyp es of foreign investment We argue here that this distinction can

b e critical in a setting where countries of unequal size engage in tax com

p etition Togive a simple example Luxemb ourg attracts a large amountof

foreign p ortfolio capital through low taxes quite in line with the results of

Bucovetsky and Wilson that small countries win tax wars At

the same time Luxemb ourg is clearly a less attractive host country for for

eign direct investment even though corp orate taxes are lowbyinternational

standards This suggests to us that while agglomeration eects or trade

costs may b e relatively unimp ortant for p ortfolio investment they cannot

b e neglected in a mo del of foreign direct investment

Conclusion

The previous literature on scal comp etition b etween countries of unequal

size has led to a general notion that suciently large countries win tari

wars whereas small countries gain from capital tax comp etition see Wilson

In this pap er wehaveintro duced an element of the new trade litera

ture trade costs capturing agglomeration eects to reconsider this issue

in a framework where two countries comp ete for the lo cation of a foreign

owned monop olist Two alternative settings have b een analyzed First when

countries have only a lumpsum prot tax subsidy at their disp osal but

face exogenous and identical transp ort costs for imp orts then b oth countries

ys oer to subsidize the rm Furthermore the maximum subsidy is will alwa

greater in the larger region However if countries are given an additional in

strument of either a tari or a consumption tax then the larger country will

no longer underbid its smaller rival and its b est oer mayinvolve a p ositive

prot tax The equilibrium outcome in b oth cases is that the rm lo cates in

the larger market paying a prot tax that is increasing in the relativesize

of this market and which is made greater for anygiven dierence in market

size when the tari consumption tax instrument is p ermitted Hence in a

setting with trade costs b oth tax and tari comp etition work in favour of

the large country

Two further asp ects of our analysis maybeworth emphasising The rst

p oint is that in the presence of the tari instrument even small dierences

in country size lead to a p ositive prot tax rate b eing charged by the large

country in the lo cational equilibrium This result maybeinteresting in view

of the obvious diculties that many existing mo dels of tax comp etition have

in explaining the p ersistence of relatively high corp orate tax rates in EU

countries In the existing literature on capital tax comp etition with its

emphasis on comp etitive markets and the absence of trade costs the optimal

capital tax for a large country is determined by terms of trade considerations

This however implies that the optimal capital tax rate should change signs

when the country switches from b eing a net capital imp orter to b eing a

capital exp orter a prediction that is clearly at o dds with empirical evidence

cf Gordon Instead in the present mo del the ability of the large

country to charge p ositive prot taxes dep ends on the advantage of a large

home market which oers a lo cationsp ecic rent to the rm Wewould

argue that this eect should not b e neglected in a mo del that tries to explain

existing taxes on corp orate prots

The second p oint concerns the available set of tax instruments a feature

that is known to b e of critical imp ortance in many optimal taxation analyses

In our mo del the threat to imp ose high taxes on imp orts either in the

form of taris or of consumption taxes serves as a bargaining to ol for

large countries enabling them to charge relatively high prot tax rates from

rms lo cating in their jurisdiction Turned around this implies that the

et barriers is likely to force these countries to elimination of internal mark

oer lower prot taxes or even subsidies for any given market size advantage

that the large country has visavis its neighb ours Imp ortantly to the extent

that current patterns of commo dity taxation include a strategic elementto

discriminate against foreign imp orts Keen similar eects can b e

exp ected from supranational eorts to align commo dity tax rates in the EU

Commo dity maythus have unexp ected rep ercussions on

the optimal levels of capital taxation with whichEUmemb er states comp ete

for foreign direct investment

Finallywe briey assess the robustness of our results in more general

settings A rst and obvious extension is to consider the case of more than

twocountries comp eting for FDI If countries dier only in p opulation size

then wewould exp ect that it is again the largest market which attracts the

rm However the optimal tari or consumption tax of the largest country

will now dep end on its relative size visavis all other countries Furthermore

the size of the second largest country will b e critical in determining which

oer the biggest country has to b eat Essentially the equilibrium prot tax

that the largest country can extract from the rm will then dep end on its

market size advantage over the next largest comp etitor

Secondly our partial equilibrium analysis has neglected the factor market

rep ercussions of foreign direct investment In particular if there is unemploy

ment in the p otential host countries then the incentives to attract the rm

will increase Brander and Sp encer Furthermore the employment

eects of a given level of foreign direct investment andthus the p er capita

gain from attracting the rm are likely to b e stronger in the small country

Hence incorp orating general equilibrium eects in factor markets may widen

the gap b etween the b est oers made b y the large and the small country

This could lead to less clearcut answers as to where the rm will settle in

equilibrium and may oer an explanation for the success of some small coun

tries such as Ireland in attracting foreign direct investmentby means of

very low tax rates

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