Welfare-improving competition for mobile capital

Abstract

This paper constructs a model in which regions provide firms with a public input, financed by taxes that residents choose to levy on capital and wage income. Self-interested government officials face incentives to provide the public input, because its positive impact on labor and capital productivity leads to larger tax bases. The positive relation between tax revenue and the public input is strengthened if capital is mobile across regions. Government officials engage in “expenditure competition,” leaving residents better off than they would be in the absence of capital mobility. To further enhance public sector incentives, residents may choose to tax capital income at a positive rate, although investment is discouraged.