1. Market size and tax competition Gianmarco I.P. Ottaviano, Tanguy van Ypersele

2. Introduction With international externalities, different country sizes, imperfect competition, and trade costs, tax competition for mobile firms is efficiency- enhancing with respect to the free market outcome. Under both scenarios, the resulting inefficiencies in international specialization and trade flows vanish when trade costs are low enough. Otherwise, only international tax coordination can implement the efficient spatial distribution of firms.

3. This paper aims to answer three related questions does tax competition distort the international allocation of capital, thus yielding an inefficient international specialization in production? does tax competition distort the pattern of international trade, thus yielding inefficient shipment of goods across countries? if such inefficiencies exist, are they related to the extent of trade integration and to the gap in economic development between countries?

4. the basic requirements that a model must satisfy in order to tackle the questions raised above are : International externalities, asymmetric sizes, imperfect competition, and trade costs While no model exists that fulfills all these requirements This is the gap we want to fill with this paper.

5. The first develops a general equilibrium model in which two countries compete for monopolistically competitive firms. The second section characterizes the free market outcome. In the third section, this outcome is shown to be inefficient, unless trade costs are low enough. The fourth section characterizes the tax competitive outcome. The fifth section shows that, unless firms are all clustered in one country, tax competition is efficiency-enhancing with respect to the free market. The sixth section concludes.

6. The model 2 countries H and F 2 factors capital and labor We denote by  (0, 1) the equal shares of total capital and labor belonging to country H.  L and (1-  )L are the numbers of workers- residing in countries H and F, respectively. Country H is assumed to be larger than country F; that is,  >1/2.

7. Preferences The associated indirect utility function is:

8. Technology The differentiated varieties and the homogeneous good are supplied by two different sectors, modern and traditional. The modern sector under increasing returns to scale and monopolistic competition. The traditional sector produces its homogeneous good under constant returns to scale and perfect competition.

9. International mobility While the traditional good is assumed to be freely traded, the modern good faces trade costs. Workers are immobile and supply labor only to their countries of residence. They can, however, invest their capital freely wherever they want.

10. Free market equilibrium workers maximize utility given their budget constraints firms maximize profits given their technological constraints all markets clear we choose the freely traded homogenous good as nume´raire. international wage is unity.

11. Demand

12. Supply A firm producing variety i in country H maximizes profit: For all sales to country H, equilibrium prices evaluate to: all active firms find it worthwhile to export if and only if

13. Finally, it is readily verified that Firms enter and exit freely so that profits are zero in equilibrium By (3)(4)(5)

14. Market clearing There are four markets: for the modern and the traditional goods, for capital and labor. In the modern sector, market clearing is ensured by the profit maximizing choices of firms facing downward sloping demand curves. In the traditional sector, market clearing is granted by the fact that, as discussed above, given quasi-linear utility, traditional consumption absorbs any supply not used as trade cost.

15. Market clearing As to capital, the share of total capital allocated by workers to country H, so  K is capital supply in country H. since each firm needs one unit of capital, capital market clearing requires

16. Location

19. Efficient location Distortions 1.market power allows firms to price above marginal cost by reducing the quantity sold. 2.The second type of efficiency loss arises in the presence of trade barriers 3.The third type of efficiency loss, which materializes once capital flows are allowed for.

20. First best The planner chooses  in order to maximize the following social welfare function:

22. Second best we define the second-best allocation as a situation in which the planner is able to assign any number of modern firms to a specific region but is unable to use lump- sum transfers from workers to firms to implement marginal cost pricing.

24. Comparison

27. Tax competition we assume that: (i) country choices are made by two national planners (governments); (ii) each national planner maximizes the welfare of its own citizens; (iii) source-based per-unit taxes on labor and capital are the only available policy tools and only fixed costs (investment) can be subsidized; (iv) each government faces an exogenously determined budget requirement; (v) taxation is not discriminatory (i.e., tax rates are the same for domestic and foreign capital).

28. Tax competition The game between the two governments takes place in two stages. In the first, governments simultaneously choose their countries’ welfare maximizing tax rates. In the second, firms and consumers make their choices taking the chosen tax rates as given.

29. Second-stage game: firms and consumers

31. First-stage game: governments

32. Tax rates and firms location it can be shown that the equilibrium tax rates are always negative for positive , being convex functions of trade costs. Therefore, tax competition leads to subsidies to capital funded through taxes on labor.

33. Moreover, equilibrium tax rates are monotonic functions of . However, while the former is increasing, the latter is decreasing in .

38. Coordination needed which is positive and smaller than (22) provided (6) holds.

39. Coordination improves overall welfare, a natural question to ask is whether it improves the welfare of both countries. Since the coordinated outcome is a tax wedge, there is a degree of freedom left. Increasing the level of capital taxation while keeping the tax differential at (25) allows governments to transfer resources from the capital exporting country to the capital-importing one. In other words, the choice of the level of capital taxation can be used as an indirect side payment mechanism in order to make coordination not only efficient but also Pareto-improving

40. under tax competition the tax rate is inefficiently high in the larger home country and inefficiently low in the smaller foreign one. The reason is the presence of a fiscal externality.

41. Conclusion the policy attitude towards tax competition should depend on the degree of trade integration. at the initial stages of an integration process, forbidding tax competition without agreeing on tax coordination is a bad idea.