Endogenizing governments' objectives in tax competition

a r t i c l e i n f o In this paper we endogenize objective functions of the regions in case the of tax competition for foreign owned mobile capital. First, considering symmetric regions and simultaneous move tax competition, we demonstrate that the competing regions can restrict 'race-to-the-bottom' in tax rates by deviating away from social welfare to net tax revenue. Moreover, it is optimal for a region to be fully revenue oriented even if that region's ultimate goal is to maximize social welfare, irrespective of whether the rival region is concerned about social welfare or net tax revenue. Next, we show that these results go through under production asymmetry and under sequential/simultaneous choice of public investment and tax rate in the case of two-dimensional competition. However, in the case of Stackelberg type competition, it is optimal for the leader region not to deviate from its ultimate goal, while the follower region always gains from being fully revenue oriented. Existing models of interregional competition for mobile capital either assume that the governments' strategies are based on the principle of social welfare maximization or the governments are assumed to be concerned only about tax revenue collected. However, the choice of governments' objective function, social welfare or tax revenue, is likely to affect the equilibrium outcomes. It is often argued that the political structure of a country plays significant role in determining its governments' objective function. Edwards and Keen (1996) and Wilson (2005), for example, argue that a leviathan government tends to maximize its net tax revenue to increase in government size so that more revenue is at the disposal of the government. Following this view, a number of authors have considered that governments maximize revenue in their models of tax competition (see, for example,, among others, subscribe to the view that governments are benevolent and maximize social welfare. In both of these two sets of papers, it is assumed that the governments' objective function, which forms the basis to determine the optimal strategies, is exogenously given. There is another strand of literature that incorporates political competition into the models of tax competition, where the utility function of the elected policy maker (representative citizen) serves as the objective function to determine the optimal strategies to compete for mobile capital none of these studies recognize the possible implications of strategic interaction among governments on the choice of their objective functions., it …