Equalization Payments in a Bargaining Model of Tax Competition

Abstract

A model in which a high-productivity region and a low-productivity region bargain with each firm in a group of mobile firms is constructed. It differs from the Han and Leach [7] model in that the firms are identical, so that its comparative statics are more tractable. The model is used to examine the allocative effects of equalization payments (both non-contingent payments and "corrective subsidies"). The equilibrium is characterized by misallocation of capital and underprovision of public goods. Underprovision is more severe in the low-productivity region than the high-productivity region. A transfer of revenue from the high-productivity region to the low-productivity region augments public goods provision in the low-productivity region, allowing that region to make more generous offers to the firms. Likewise, underprovsion becomes more severe in the high-productivity region, so that its offers become less generous. Equilibrium is attained by a movement of firms from the high-productivity region to the low-productivity region, reducing the misallocation of capital.