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International Economic Review

TAX COMPETITION IN A SIMPLE MODEL WITH HETEROGENEOUS FIRMS: HOW LARGER MARKETS REDUCE PROFIT TAXES

Authors

  • Andreas Haufler,

    1. University of Munich, Germany; University of Tübingen, Germany
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  • Frank Stähler

    1. University of Munich, Germany; University of Tübingen, Germany
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    • Paper presented at the meeting of the Association of Public Economic Theory in Istanbul, at the European Trade Study Group meeting in Rome, and at conferences at CESifo and the Max Planck Institute in Munich. We thank Johannes Becker, Ron Davies, Carsten Eckel, Clemens Fuest, Kai Konrad, Sebastian Krautheim, Ferdinand Mittermaier, Gareth Myles, Michael Pflüger, Evelyn Ribi, Jens Südekum, and Ian Wooton for many helpful comments. We also wish to thank two anonymous referees for their detailed and constructive suggestions. Haufler acknowledges financial support from the German Research Foundation (Grant No. HA 3195/8-1). Please address correspondence to: Andreas Haufler, Department of Economics, University of Munich, Akademiestr. 1/II, Munich, Bavaria 80799, Germany (DE). Phone: +49-89-2180-3858. Fax: +49-89-2180-6296. E-mail: Andreas.Haufler@lrz.uni-muenchen.de.


  • Manuscript received September 2011; revised April 2012.

Abstract

We set up a simple two-country model of tax competition where firms with different productivity decide in which location to produce and sell output. In this model, a unique, asymmetric Nash equilibrium is shown to exist, provided that countries are sufficiently different with respect to their exogenous market size. Sorting of firms occurs in equilibrium, as the smaller country levies the lower tax rate and attracts the low-cost firms. A simultaneous expansion of both markets that raises the profitability of firms intensifies tax competition and causes both countries to reduce their tax rates, despite higher corporate tax bases.

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