Agglomeration and government spending

Abstract

It is widely believed that globalization, through increased factor mobility, will exert a downward pressure on tax rates and hence on public expenditures. Recent advances in the new economic geography (NEG) literature have, however, shown that such a ‘race to the bottom’ is not inevitable. Even with perfect factor mobility, a positive tax differential between core and peripheral countries can persist as long as the agglomeration rent, that is associated with being located in the agglomeration, exceeds the tax gap. In these NEG models the relevance of government spending as a determinant of agglomeration is, however, unduly neglected. The focus is on tax rates only and on the stability of core-periphery equilibria. Using a NEG model where the provision of public goods is allowed to influence the location choices of economic agents and starting intially from a spreading instead of a core-periphery equilibrium, we show that governments can affect the spatial equilibrium through their provision of public goods. Our main finding is that the introduction of public goods fosters agglomeration in the sense that it makes the spreading equilibrium unstable