We analyze an environment with asymmetric information where a country tries to attract a multi-national corporation. The country can use both taxes and grants to meet its objective of maximizing net revenues. We show that when the country has private information it can often convey it via its choice of a tax-grant pair. When the tax rates are unbounded the country is able to extract the full surplus. The existence of an upper bound can in some cases reduce the payoff to a stronger country

Kaplan, Todd R.

Luski, Israel

Wettstein, David

Open Research Exeter

Government policy towards multi−national corporations Todd KaplanUniversity of ExeterIsrael Luski David WettsteinBen−Gurion University of the Negev Ben−Gurion University of the NegevAbstractWe analyze an environment with asymmetric information where a country tries to attract amulti−national corporation. The country can use both taxes and grants to meet its objective ofmaximizing net revenues. We show that when the country has private information it canoften convey it via its choice of a tax−grant pair. When the tax rates are unbounded thecountry is able to extract the full surplus. The existence of an upper bound can in some casesreduce the payoff to a stronger country.The comments and suggestions of the associate editor are gratefully acknowledged.Citation: Kaplan, Todd, Israel Luski, and David Wettstein, (2003) "Government policy towards multi−national corporations."Economics Bulletin, Vol. 6, No. 3 pp. 1−8Submitted: September 26, 2002.  Accepted: May 20, 2003.URL: http://www.economicsbulletin.com/2003/volume6/EB−02F00002A.pdf1 IntroductionGovernments at local and national levels are vigorously pursuing large corpo-rations for the purpose of having them set up headquarters or plants in theirrespective jurisdictions: In 1995 Intel received a grant of $608 million (spreadover several years) to build a $1.6 billion plant in southern Israel. The Toyotacorporation secured a grant of $125 million from the State of Kentucky inreturn for locating an $800 million plant employing 3000 workers.Success in attracting these ventures is likely to generate employmentgains, increased tax revenues and possible stimulation of local productionthrough beneficial spillover eﬀects. The magnitude of these factors dependson the characteristics of the corporations relocating into the region in ques-tion.A major diﬃculty in attracting suitable corporations stems from asym-metries of information between the possible incoming corporations and thediﬀerent regions. Bond and Samuelson [1986] focus on the role played by pri-vate information on part of the countries and study conditions under whichdiﬀerent countries oﬀer diﬀerent tax schedules resulting in tax holidays thatin eﬀect reveal their private information.Other scenarios of competition to attract firms have been studied: Blackand Hoyt [1989] focus on tax burden considerations. King, McAfee andWelling [1993] analyze an uncertain environment with sunk costs. Haaprante[1996] considers environments where firms decided upon the percentage offirm activity to be carried out in each location and countries use a menuauction to attract firms (see Bernheim and Whinston [1986]).We analyze an environment similar to the Bond and Samuelson [1986]model. The country is assumed to have private information on its produc-tivity. We analyze the impact of introducing grants in addition to the taxesstudied by Bond and Samuelson as a policy tool to attract multi-nationalcorporations. The country’s objective is to maximize tax revenues net of anygrants and the firm’s objective is profit maximization. We analyze the re-sulting game and show that in the presence of grants, tax holidays disappear.We also show that grants generate the appropriate payoﬀs to coincide withthe firm’s reservation value.Finally, we consider the case where the tax rates used are bounded fromabove due to either political or incentive considerations. We analyze theresulting equilibria and reach conclusions similar to those without tax raterestrictions.12 A privately informed countryWe build upon the Bond and Samuelson [1986] model by adding the policytool of grants in addition to ad valorem taxes. This environment consists ofone firm and two countries (home and foreign) and extends over two periods.The firm chooses to locate its plant in either of the two countries. If thefirm chooses to locate in the foreign country, it incurs a fixed cost K. Ifthe firm stays in the home country for both periods, it will earn profits ofV1 — its reservation value. If the firm chooses the foreign country in period1 it can relocate back to the home country in period 2 and earn profits ofV2 for period 2. The firm’s profits in the foreign country depend on theproductivity of the foreign country and the schedule of taxes and grantsoﬀered. The foreign country’s productivity (type) is either H (high) withprobability p or L (low) with probability (1− p), and is privately known tothe foreign country. Before-tax, per-period profits are RH in an H countryand RL in an L country. At the beginning of period 2, a firm that chosethe foreign country learns the country’s type and may relocate back to thehome country. Both country and firm discount second period income by afactor of δ. We say it is eﬃcient for a firm to enter a country of type i ifRi −K + δ ·Max{Ri, V2} ≥ V1.We assume the foreign country can commit to a given schedule of taxesand grants for only one period. Hence, being a net revenue maximizer, it willextract all the surplus in the second period, leaving the firm at its reservationvalue V2.2.1 EquilibriaAn equilibrium consists of the strategies adopted by each type of foreigncountry, the beliefs held by the firm, and the firm’s strategy. Potential equi-libria are either separating or pooling.Bond and Samuelson found that there exist separating equilibria wheretax holidays (lower first period tax rates) are used as a signal by a countryto indicate that it is an H country. Let us now examine our model to see ifthis result holds when we introduce the possibility of grants.In a separating equilibrium an H country oﬀers a tax rate tH and a grantGH , while an L country oﬀers tL and GL with (tH , GH) 9= (tL, GL). On theequilibrium path of a separating equilibrium, the firm knows the country’sproductivity with certainty. Thus, we should examine what happens un-der complete information. We begin by considering the case where undercomplete information each country type would have a positive payoﬀ whenoﬀering the firm its reservation value and in equilibrium the firm chooses to2enter each type of country. The payoﬀ for a country of type i that uses atax-grant policy of type j is given by the function: Uij = U(tj , Gj , Ri) =tjRi −Gj +Max{δ(Ri − V2), 0} where i and j can be either H or LThe analysis of such an equilibrium proceeds through the following seriesof lemmata.Lemma 1 In a separating equilibrium when entry occurs for both types ofcountries, an H country oﬀers both a higher tax rate and a higher grant,tL ≤ tH and GL ≤ GH .Proof. It must be that neither type of country could gain by imitatingthe other type. Hence (since the firm enters in either case): Uii ≥ Uij for alli and j. Thus, type L should not gain by using the strategy of type H:tHRL −GH +Max{δ(RL − V2), 0} ≤ tLRL −GL +Max{δ(RL − V2), 0}=⇒ tHRL −GH ≤ tLRL −GLSimilarly type H should not gain by using the strategy of type L:tLRH −GL ≤ tHRH −GHThese two conditions imply thattL(RH −RL) ≤ tH(RH −RL)⇒ tL ≤ tH (since RL < RH)Since the first condition implies(tH − tL)RL ≤ GH −GLWe have, GL ≤ GH .The intuition for this lemma is the following. The revenue diﬀerence bychoosing a higher tax rate for an H country is greater than that for an Lcountry. Thus, a higher grant in an H country will give proper incentive foreach type of country to choose the appropriate policy. This is a similar resultto that of screening contracts.Lemma 2 Whenever entry occurs, the firm’s payoﬀ in a separating equilib-rium equals its reservation value.Proof. Assume by way of contradiction that the firm enters an L countryand its payoﬀ exceeds its reservation value so that (1−tL)RL+GL+δV2−K >3V1. Using this inequality, an L country’s equilibrium payoﬀ satisfies thefollowing inequalityULL = tLRL −GL +Max{δ(RL − V2), 0} < RL − V1 + δV2 −K +Max{δ(RL − V2), 0}In such a case an L country could deviate and oﬀer tL = 1 and GL =V1 +K − δV2 + ". Under this oﬀer the firm would enter the foreign countrysince it would make profits of V1 +K + " (regardless of country type) whichexceed its reservation value. This leads to a contradiction since an L country’spayoﬀ would be RL− (V1+K−δV2)+Max{δ(RL−V2), 0}−" which exceedsits equilibrium payoﬀ for a small enough ". Similarly we can show that withan H country the firm’s payoﬀ must coincide with its reservation value aswell.Lemma 3 In a separating equilibrium when entry occurs for both types ofcountries, the tax rate oﬀered by an H country equals 1.Proof. By Lemma 2, if a firm enters for both types of countries, we have:(1− tL)RL +GL + δV2 −K = V1and(1− tH)RH +GH + δV2 −K = V1Combining we get:(1− tL)RL +GL = (1− tH)RH +GHIn order for an L country to not have incentive to imitate an H country(derived in the proof of Lemma 1), we havetLRL −GL ≥ tHRL −GHAdding we get:RL ≥ RH + tH(RL −RH) = (1− tH)RH + tHRLTherefore, tH = 1.So far we have provided several conditions a separating equilibrium mustsatisfy. We now proceed to show (by construction) that an equilibrium exists.4Proposition 1 If it is eﬃcient for a firm to enter an L country, then aseparating equilibrium exists where the firm enters for both types of countriesand where: tH = 1 and GH = V1−δ ·V2+K and (tL, GL) satisfy (1−tL)RL+GL = V1 − δ · V2 +K with tL < 1.Proof. Since an H country pays a firm its reservation value it has noincentive to deviate. Thus, it is reasonable to assume that a firm believes anyoﬀer that deviates comes from an L country. Hence, an L country also has noincentive to deviate. These payoﬀs ensure that the firm earns its reservationvalue for entering and countries have incentive to oﬀer these payments sincewe assumed each country has a positive payoﬀ when oﬀering the reservationvalue.We now analyze the case of a pooling equilibrium. In a pooling equilib-rium both types of countries oﬀer the same pair (t,G) and the firm believesit faces an H country with probability p.Lemma 4 In a pooling equilibrium, t = 1.Proof. The equilibrium payoﬀ for anH country is: tRH−G+δ(RH−V2).Assume by way of contradiction that t 9= 1, an H country can deviate tot = 1 and G = G + (1 − t)[(1 − p)RL + pRH ]. The firm when faced withsuch an oﬀer would enter since it gets the same as in the pooling equilibriumregardless of the country’s type. An H country’s payoﬀ will then be:RH −G− (1− t)[(1− p)RL + pRH ] + δ(RH − V2)Since t, p < 1 and RH > RL, we have (1− t)RH > (1− t)[(1− p)RL + pRH ].Rewriting gives us,RH − (1− t)[(1− p)RL + pRH ] > tRHand hence an H country’s payoﬀ is thenRH −G− (1− t)[(1− p)RL + pRH ] + δ(RH − V2) > tRH −G+ δ(RH − V2)Thus, an H country has an incentive to deviate which is a contradiction;hence, the tax rate in a pooling equilibrium must equal 1.Since the tax rate is 1, the firm’s payoﬀ is independent of the country’stype. The optimal action of the country is then to oﬀer the minimal grantnecessary to attract the firm which leads to the following result.5Proposition 2 If it is eﬃcient for a firm to enter an L country, then apooling equilibrium exists and is given by t = 1 and G = V1 − δV2 +K forboth types of countries.Proof. As before an H country cannot gain by deviating, therefore it isreasonable to assume any deviation is by an L country. However, with suchbeliefs an L country cannot gain by deviating either. Note that the firmwants to enter independent of country type and eﬃciency for an L countryensures that for both types of countries it would be worthwhile to oﬀer thiscontract.While for a given environment there may exist multiple equilibria, acrossany of these equilibria the profits for either the firm or the country do notvary. In contrast to the Bond and Samuelson analysis tax holidays are notused as a signal, and furthermore signalling if done at all is with higher taxrates.2.2 A Maximum Tax RateImposing high tax rates may not be viable due to a host of reasons. Henceit is of interest to examine our findings in an environment where tax ratescannot exceed a maximum denoted by tmax < 1. Such environments allow asbefore both for separating and pooling equilibria, both of which are analyzedin the following propositions.Proposition 3 In a separating equilibrium when entry occurs for both typesof countries, tH = tmaxProof. One can show in a similar method to Lemma 2 that in a sepa-rating equilibrium an L country will extract all the surplus (since the firmalready thinks the country is of type L the country can just lower the grantuntil no surplus is left). However, the same cannot be done for an H country.Assume that the beliefs are such that with any deviation, the firm believesthe country is of type L. An H country can always deviate to the maximumtax rate and give a grant G that would induce the firm to enter with thebeliefs that it is an L country.(1− tmax)RL +G + δV2 −K = V1The firm will actually receive(1− tmax)RH +G + δV2 −K = V1 + (1− tmax)(RH −RL)6The firm thus may have a surplus as high as (1−tmax)(RH−RL) when enteringan H country. Therefore, the payment a firm receives when entering an Hcountry is such that(1− tH)RH +GH + δV2 −K ≤ V1 + (1− tmax)(RH −RL)≤ (1− tL)RL +GL + δV2 −K + (1− tmax)(RH −RL)As stated in the proof of Lemma 1, in order for an L country not to imitatean H country we must havetHRL −GH ≤ tLRL −GLCombining these yields(1− tH)RH + tHRL ≤ RL + (1− tmax)(RH −RL)This simplifies to0 ≤ (tmax − tH)(RL −RH)Since RH ≥ RL, we have tH = tmax.Proposition 4 In a separating equilibrium when entry occurs for both typesof countries, a firm entering an H country makes a strictly positive surplus.Proof. Assume by contradiction that the surplus is zero. Then, theconditions of Lemma 3 are satisfied leading to the conclusion that tH = 1.Violating the restriction that tH ≤ tmax < 1.We thus see that a maximum tax rate potentially lowers the amount ofsurplus a high country can extract.Proposition 5 In a pooling equilibrium the common tax rate coincides withthe maximum tax rate.Proof. Let t and G be the oﬀer in the pooling equilibrium. Assume byway of contradiction that t < tmax. In this case an H country can deviate toan oﬀer of t + " and G that would be profitable for an H country and notprofitable for an L country (assuming entry still occurs). Thus we have(t+ ")RH −G > tRH −G(t+ ")RL −G < tRL −GThese are satisfied when"RH +G > G > "RL +G7(such a G exists since RH > RL). When presented with such an oﬀer, thefirm would then realize that the country is of type H and will enter if(1− t− ")RH +G + δV2 −K ≥ V1Since G > "RL +G, we have(1− t− ")RH +G + δV2 −K ≥ (1− t)RH − "(RH −RL) +G+ δV2 −KHowever, in the pooling equilibrium(1− t)[(1− p)RL + pRH ] +G+ δV2 −K ≥ V1Since RH > (1−p)RL+pRH , for small enough ", we have (1−t)RH−"(RH−RL)+G+δV2−K ≥ V1. Thus, the firm still wants to enter and an H countrywould gain from such a deviation.Notice that even though the maximum tax rate is charged in a poolingequilibrium, the firm would gain a surplus when the country is of type H (thefirm will not gain if the country is of type L) since on average the firm shouldmake its reservation value. Thus, a maximum tax rate will hurt profits of anH country in a pooling equilibrium. If it is eﬃcient for a firm to enter an Lcountry, then as before both types of equilibria exist.The intuition for our results is that it is more eﬀective for an H country tosignal via grants. An H country can raise the tax rate with an accompanyingchange in the grant keeping its payoﬀ constant, while making it more costlyfor an L country to imitate it.3 ConclusionsWe analyzed an environment where a country tries to attract a multi-nationalcorporation. The Bond and Samuelson [1986] model was augmented by al-lowing the foreign country the choice of grants as well as taxes. We showedthat tax holidays disappear while grants are an important part of policy.Environments where there is private information on both sides (the firmand the country) remain to be thoroughly analyzed. It is also interestingto see how changes in the bargaining power (which may result from theintroduction of more countries and firms) aﬀect the results. Furthermore, theuse of taxes and subsidies may also pose problems relating to the politicalviability of these measures: there might be popular opposition to grants,whereas industry lobbies might strongly object to high tax levels.8ReferencesBernheim, D., and M. Whinston (1986) “Menu Auctions, Resource Alloca-tion, and Economic Influence” Quarterly Journal of Economics 101, 1-31.Black, D. A., and W. H. Hoyt (1989) “Bidding for Firms” American Eco-nomic Review 79, 1249-1256.Bond, E. W. and L. Samuelson (1986) “Tax Holidays as Signals” AmericanEconomic Review 76, 820-826.Haaprante, P. (1996) “Competition for Foreign Direct Investment” Journalof Public Economics 63, 141-153.King, I., P. R. McAfee and L. Welling (1993) “Industrial Blackmail: DynamicTax Competition and Public Investment” Canadian Journal of Economics26, 590-608.9

Government policy towards multi-national corporations

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Government policy towards multi-national corporations

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