The Region

On the efficiency effects of tax competition for firms

Joe Mattey - Senior Economist
Mark Spiegel - Senior Economist, Federal Reserve Bank of San Francisco

Published June 1, 1996  |  June 1996 issue

Arguments against allowing state and local governments to compete against each other with tax incentives for the outcome of specific firm location decisions roughly can be separated into two categories, those which argue that such competition has adverse fairness consequences by reducing the corporate share of the tax burden, and those which argue that it has adverse impacts on economic efficiency. As economists, we leave the fairness arguments to others. In this note, we concentrate on the merits of efficiency arguments against state and local tax competition. We find such arguments weak, at best. Indeed, such tax competition may actually enhance efficiency, as we describe below.

One of the potential consequences of tax competition is a reduction in government revenues, which could constrain government services to suboptimal levels. However, formal demonstrations of this result have relied on models where the local governments are limited to a single tax instrument. Allowing other revenue sources can overturn this result. Indeed, the limited empirical evidence suggests that revenue losses from competition over state and local corporate income and property tax receipts are at least partly offset by increased taxes from other sources, such as individual income taxes or sales taxes.

Even if such competition does inhibit revenue-raising by state and local governments, this only reduces efficiency if any resulting suboptimal spending from state and local government revenues is not offset by increased spending from federal government revenues. Our current alignment of responsibilities among levels of government is heavily tilted toward fiscal federalism and likely results in large offsets and even the overprovision of some public goods to particular areas. In this situation, the welfare implications of increasing revenue-raising capabilities and the level of state and local public good provision are unclear.

A second argument against tax competition is that area governments allegedly end up, on average, with fewer jobs and tax revenues from the target firm than they had anticipated. This type of situation is known as the "winner's curse" and can arise in one-shot, sealed-bid auctions when bidders have different beliefs about the value of an object. If people offer bids at their individual expected values, the winning bidder will be "cursed" in the sense that the true value of the object will be lower than his bid. This occurs because, all else equal, the winning bidder will be the individual who has the most overoptimistic estimate of the value of the object. In practice, however, officials who are aware of the "winner's curse" can adjust their bids accordingly. Moreover, the sequential nature of the tax competition process can provide an opportunity for learning about the extent of incentives offered by others. For both of these reasons, systematic overbidding need not emerge.

A third argument put forth by critics of tax competition is that the tax breaks are offered to the most mobile producers and not to relatively captive producers. In principle, this could lead to relative overproduction of the types of goods made by the most mobile producers. However, firm mobility is primarily determined by the timing of fixed investments. Most firms are relatively mobile prior to locating production in a particular place, but the start-up of operations often requires substantial investments which then renders firms relatively immobile until that capital investment has depreciated. Thus, tax competition should be viewed as yielding an advantage to investing in and operating new physical capital over, say, paying employees to maintain the operability of older, less efficient physical capital. Currently, the returns to investment in new physical capital are subject to multiple taxation in our overall fiscal system, first as corporate income and then again as individual income when they are received as dividends or capital gains. Many claim that this leads to a tax bias against business investment. If so, then tax competition can help reduce the bias against business investment.

There are a number of other salient arguments that state and local government tax competition can enhance efficiency. One is that properly managed tax competition can create positive "spillover effects" within a community by attracting or retaining firms with high levels of these external benefits. Localities can use tax incentives to help nurture "industry clusters" which exploit "agglomeration economies," the increases in efficiency of production from the geographic concentration of related activities.

Some of the efficiency gains from tax competition stem from the ability of differential tax "prices" across communities and firms to overcome information problems. If a locality has better information than the firm itself about the value of the services the firm can derive from the community, then the willingness of the government in that jurisdiction to offer lower tax rates signals to the firm the high productivity of that location. The fact that incentives often take the form of "tax holidays," reduced tax rates in the early years of a newly resident firm's operation, is consistent with such a scenario, because the willingness of the government to raise taxes in later years, when the firm will again be mobile, also signals that the government believes that the firm will choose to stay, once it knows the true productivity of the location.

Another argument for tax competition stems from the fact that many government-provided goods are "priced" at the average cost of producing them, even when this exceeds the marginal cost of providing additional public goods. By offering some discounts from the uniform, average-cost tax prices, the government can move closer to the efficient level of public good provision, for example, by producing more to meet the needs of a newly attracted firm.

Finally, all of the above-mentioned efficiency benefits of allowing state and local governments within the United States to engage in tax competition with each other also pertain to allowing these localities to compete with potential foreign investment destinations. Any efforts to limit tax competition among U.S. locations will not be able to control foreign tax policy and could place U.S. communities at an inappropriate disadvantage.

This paper, published by the Minneapolis Fed for "The Economic War Among the States," a conference held in Washington, D.C., on May 21-22, 1996, is reprinted in this issue of The Region.

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