Tax Competition with Mobile Labor, Residents, and Capital

Abstract

We construct a unifying model of tax competition that includes mobile workers, mobile residents, and mobile capital – and is therefore appropriate for the study of local government policy. Local governments are atomistic with respect to the world capital market, but are linked by commuting patterns, the cost of which is endogenously determined by congestion. Capital taxation creates fiscal externalities, which then alter decisions both about where to live and work. These fiscal externalities result from changing commuting patterns: when a jurisdiction increases its industrial capital tax rate, some workers change their work location to another jurisdiction, raising public good provision there. In this way, competition for workers affects competition for households. Commuting gives rise to “tax exporting,” with a higher capital tax in the (central) city partially borne by non-resident commuters from the suburbs, allowing the capital tax to remain optimal even when head taxes are available. We also consider taxes on labor, residents and property. Against, this backdrop, we show, consistent with the empirical literature, that even though jurisdictions are price-takers in the world capital market, they strategically react to the policies of other jurisdictions due to commuting linkages. This resolves an important inconsistency between the theoretical and empirical literature by making theoretical models of atomistic jurisdictions that are appropriate for local policy choice consistent with the empirical evidence that localities strategically interact in capital taxes.