Tax Competition When Governments Lack Commitment: Excess Capacity as a Countervailing Threat

Abstract

Consider a multinational firm that can produce for the world market from two countries. In each country the firm has to make a costly ex ante investment in capacity, after which each government chooses a tax rate, and then the firm determines output levels. If there were only one country there would be the standard timeinconsistency problem: The government would set a confiscatory tax ex post, the firm would realize this ex ante and no investment would be made. The interesting point of this paper is that the situation is very different when there are two countries. The firm invests in both countries so as to gain leverage ex post. If the firm holds more capacity than is needed to meet world demand, then this induces tax competition for capacity utilization among governments ex post because the firm can threaten to serve the market at least partially from a plant in a different country. Competition leads to low enough tax rates to justify the initial investment in excess capacity when capacity costs are sufficiently low.' When capacity costs are too high, the firm will not invest at all, as the standard timeinconsistency problem suggests. Thus the paper generates and combines tax competition and lack of government commitment within a single framework. The above logic provides also a novel argument for becoming a multinational firm. There is some evidence in support of the strategic use of excess capacity. For example, General Motors (GM) announced it will build almost identical plants in several risky countries, which allows GM to shift production easily. At the same time, the newly established capacity will probably exceed GM's sales. Another application is the problem of how multinationals export oil from the Caspian Sea. The Caspian Sea is surrounded by politically unstable countries. Multinationals started to build and lobby for multiple pipelines through several countries in order to keep transit fees low. These and other applications are discussed in more detail in Section V. The paper sheds new light on the relationship between multinational firms and host governments. On the one hand, a multinational firm can be viewed as the powerful agent in the relationship because the firm decides in which country to invest. Eager governments often offer substantial tax benefits in order to attract investment. This view is underlying the literature on tax competition (see, for example, John D. Wilson, 1986; Dan A. Black and William H. Hoyt, 1989; Ian King et al., 1993). On the other hand, and in a separate literature, multinational firms are portrayed as the potential victims of host governments, who may renege on tax promises after the firm has made a sunk investment and has become partially immobile (see, for example, Eric W. Bond and Larry Samuelson, 1989; Chris Doyle and Sweder van Wijnbergen, 1994; Jonathan Thomas and Tim Worrall, 1994). Hence, the host government is the powerful agent, and this may lead to underinvestment if anticipated by the firm.2 While both views capture elements of truth, it is unsatisfactory that our understanding of the relationship seems to * Department of Economics, University of Colorado, Boulder, CO 80309 (e-mail: janeba@colorado.edu). This research was undertaken while I was at Indiana University in Bloomington. I am grateful to Mike Baye, Susanne Janeba, Dave Schmidt, Greg Shaffer, Jay Wilson, and two anonymous referees, as well as participants at the Stanford Institute for Theoretical Economics 1998, and workshop participants at the Universities of Bonn, Colorado, Indiana, Michigan, Munich, Pennsylvania State, and Toronto for very helpful comments. The usual disclaimer applies. l In a different context, Patrick J. Kehoe (1989) considers also tax competition after a private-sector decision is made. In his model, however, atomistic individuals decide on savings and cannot influence the degree of tax competition. 2 It should be noted that in the second literature strand tax holidays are sometimes derived endogenously. In an infinite-horizon game, tax holidays help overcome lack of commitment. See, for instance, Doyle and van Wijnbergen (1994).