Location Tax/Subsidy Competition: When Governments Set Their Policies After Firms Choose Their Locations

Abstract

In this study, we examine the location tax/subsidy competition between two countries when governments set tax or subsidy policies after firms have decided their location using a third-market model. The previous literature on tax competition with the choice of production location of firms has relied on a model in which governments set tax/subsidy policies before firms choose their production location between countries. However, if governments cannot commit to their policies in advance, the timing of decision-making changes so that governments determine their tax/subsidy rates after firms choose their location. Considering the different timings of the game, we show the following results. First, firms choose to stay in the countries in which they were originally established and governments subsidize the firms located in their countries. As a result, exporting countries fall into excessive subsidization competition, whereas firms can obtain higher profits than in the no-subsidization case. Second, when tax/subsidy authorities are tax-revenue maximizers, there are two different equilibria in tax competition in which each firm chooses to locate in different countries. Social welfare is larger when governments are tax-revenue maximizers than when they are social-welfare maximizers, whereas firms' profits are smaller when governments are tax-revenue maximizers.