The effects of agglomeration on tax competition: evidence from a two-regime spatial panel model on French data

Abstract

This article studies how agglomeration economies affect tax competition between local jurisdictions. We develop a theoretical model with two main testable predictions: in a setting where agglomeration forces lessen the responsiveness of capital to tax, high-regime agglomeration jurisdictions should adopt a rent-taxing behavior, and they should react less to their neighbors’ tax policies. The panel dataset spans the period from 1995 to 2007 and focuses on the local business taxes set at the French mid-subnational jurisdiction level of departements. First, instrumental variables estimates indicate that attractive jurisdictions capture a significant part of firms’ agglomeration rent by levying higher tax rates. An increase by 1% of the localization economies indicator (a specialization index) leads to increasing the business tax rate by 0.43%. Second, local tax setting behaviors are characterized by a mimetic behavior, with best response functions that slope upwards. We propose a two-agglomeration-regime spatial lag model to estimate through ML the relationship between tax competition and attractiveness. Our main result shows that both are linked and tax mimicry is less pronounced if a jurisdiction is agglomerated. Specifically, in response to a decrease in the tax rate of neighboring local governments by 1%, local governments with strong agglomeration economies reduce their tax rate by 0.4% against 0.6% for local government characterized by a low-agglomeration regime. We show that the classical one-size-fits-all-case of a single regime of agglomeration suffers from a 40% downward bias for low-agglomeration jurisdictions. We draw the link to policy praxis by discussing the optimal design of equalization schemes.