Tax Competition and Economic Geography

Tax competition between two countries is considered in a trade–and–location setting with differentiated products and monopolistic competition. There are two groups of workers, mobile ones and immobile ones. Taxes are used for producing a public good. It is shown that an equilibrium with mobile workers dispersed across countries is destabilized by increased taxes on these mobile workers—even for perfectly coordinated tax increases. It is also shown that while tax competition gives rise to standard distortions in a tax–competition game when mobile workers are dispersed, different distortions result when they are concentrated in one country.