Nash equilibria in models of fiscal competition with unemployment

Abstract

This study examines two different fiscal competition games under labor market imperfections. Given that capital moves across regions and affects regional employment, governments must choose the expenditure level and tax rate on such mobile capital by accounting for the effects of fiscal variables on both capital and labor. Therefore, governments may play these games with either the tax rates on mobile capital or with public expenditures. The presence/absence of absentee ownership of capital and employment externalities are significant factors that characterize two distinct Nash equilibria, one that occurs with tax competition and the other with expenditure competition. Contrary to the existing literature, tax rates under tax competition are likely to be lower than those under expenditure competition owing to employment externalities. In some cases, governments prefer to choose government expenditure as their strategic variable rather than the tax rate. The presence of employment externalities motivates governments to use such expenditure as the variable through which it may strengthen strategic effects.