Tax competition, location, and horizontal foreign direct investment

Abstract

We develop a model of capital tax/subsidy competition in which imperfectly competitive firms choose both the number and the location of the plants they operate. The endogenous presence of horizontal multinationals is shown to attenuate the “race to the bottom” and yields some results that are opposite to traditional findings in the tax competition literature. First, in the presence of horizontal multinationals, increasing subsidies decrease firms' profits by exacerbating price competition due to more firms ‘going multinational’. Second, instead of being always subsidized, capital may actually be taxed in equilibrium. Third, taxes/subsidies become strategically independent policy instruments, instead of being strategic complements. Last, there may exist multiple equilibria with either low or high subsidies.capital tax competition; international trade; horizontal multinationals; foreign direct investment; imperfect competition