Taxation, Infrastructure, and Endogenous Trade Costs in New Economic Geography

This paper presents a New Economic Geography model with distortionary taxation and endogenized trade costs. Tax revenues finance a public good, infrastructure. We show that the introduction of costly public investment in infrastructure increases agglomerative tendencies. With respect to the regions’ sizes, in the periphery, the price-index for manufacturing goods decreases, whereas for the core, the price-index is rather high since the distortionary effect of taxes dominates. ’Free riding’ − or, in terms of regional policy, externally funded infrastructure investment − is beneficial for the periphery, which can devote all its tax revenue to local demand support, generating a positive home market effect and driving the catch-up process.