Tax rate and tax base competition for foreign direct investment

Abstract

This paper examines empirically whether governments behave strategically when setting corporate tax rates and tax bases, and—if so—how they react to changes in other countries’ tax rates and bases. Specifically, we estimate the slopes of tax policy reaction functions and examine how marginal changes in trade costs and GDP affect tax policies in the Nash equilibrium. The estimated slopes and comparative static effects can be rationalized in a model in which governments compete for foreign direct investment (FDI). Using estimated policy reaction functions, we demonstrate that observed changes in corporate tax systems are consistent with tougher competition for FDI following regional trade integration.