Abstract
This article aims at assessing the empirical relevance of New Economic Geography models of tax competition. We rely on a simple model to specify tax reactions functions, which we estimate with a panel covering (up to) 26 OECD countries over the period 1982 to 2006. We provide striking support for the two main predictions regarding the slope and the constant of the reaction function: national governments seem to adjust their corporate tax rate towards the level chosen in countries that are more populated, and they tend to set higher corporate tax rates when their country enjoys a high real market potential. Through the latter effect, trade integration exerts a positive influence on the level of corporate taxation. However, using a theoretically grounded index of bilateral trade integration, we also show that trade liberalization gives rise to significant tax interactions in the setting of effective average tax rates in the case of European countries, thus exerting a downward pressure on corporate tax rates.
Highlights
According to the seminal models of tax competition (Zodrow and Mieszkowski, 1986; Wilson, 1991; Bucovetsky, 1991), capital mobility leads governments to strategically decrease their capital tax in order to prevent their country from suffering large capital outflows
We provide striking support for the two main predictions regarding the slope and the constant of the reaction function: national governments seem to adjust their corporate tax rate towards the level chosen in countries that are more populated, and they tend to set higher corporate tax rates when their country enjoys a high real market potential
Our findings reveal that bilateral trade integration gives rise to significant interactions with respect to effective average tax rates when we consider a subsample of European countries
Summary
According to the seminal models of tax competition (Zodrow and Mieszkowski, 1986; Wilson, 1991; Bucovetsky, 1991), capital mobility leads governments to strategically decrease their capital tax in order to prevent their country from suffering large capital outflows. Davies and Voget (2011) provide empirical evidence for this finding and show that governments respond more to taxes set in EU countries as compared to non-EU countries, suggesting that European enlargement might exacerbate tax competition. None of these studies investigate the specific – and ambiguous – impact of trade integration on taxes. A first contribution this paper makes to the literature is to translate the NEG framework into an empirical model that allows us to determine how trade integration affects tax competition This is important as it provides the tools to evaluate, for example, whether further trade integration among OECD countries would exacerbate or dampen tax competition
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