Competition for foreign capital: Endogenous objective, public investment and tax

Abstract

In this paper we endogenize the objective functions of the regions as well as their decision to provide public investment in a model of competition for foreign owned mobile capital. 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. 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. Moreover, we demonstrate that the regions have unilateral incentive to spend on public investment, except in case of perfect spillover. In equilibrium, both the regions spend on public investment and end up with Pareto inferior outcomes.