New Economic Geography and Tax Competition in the PRC: A Firm-Level Data Analysis with Policy Implications

Abstract

During 2000–2006, nearly 4,000–5,000 new foreign and domestic enterprises entered the export industry of the People’s Republic of China (PRC) yearly, with geographic concentration along the coastal areas. This paper empirically analyzes the spatial determinants of new entrants by applying traditional comparative advantage analysis, new economic geography of agglomeration theory, and tax competition theory by resource flow model. The heterogeneity of firm ownership and trade type enhances the understanding of investment location decisions. Processing traders differ substantially from nonprocessing traders in response to changes in wage cost, level of development in infrastructure, and proximity to the Pacific coast. The presence of foreign-invested enterprises creates a beacon effect on subsequent foreign and domestic investors. The paper also finds that agglomeration plays a greater role for investors specializing in the processing goods trade and highly skill-intensive or research and development-intensive production. Benefits from reduction in the value added tax rate and corporate income tax rate play an evident role for foreign investors and Hong Kong, China and Taipei, China investors in processing trade sector. The PRC’s policy makers intend to transform the “internationalization” process through attraction of foreign investment toward “localization” by reducing the processing good trading portion and by increasing the supply of domestically produced intermediate inputs for their exports. As the PRC moves up the high-value supply chain, expands its domestic market, and exports skill-intensive goods, processing goods traders may consider new locations or business models.