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Finance and Economics Discussion Series
Finance and Economics Discussion Series logo links to FEDS home page State Capital Taxes and the Location of Investment: Empirical Lessons from Theoretical Models of Tax Competition
Brian Knight

Abstract: Applying insights from theoretical tax competition models, this study of manufacturing investment and taxes in U.S. states makes four contributions to the empirical tax competition literature. First, while the existing empirical literature has assumed exogenous tax rates, the theoretical model, which endogenizes state tax rate choices, demonstrates that tax rates and investment decisions are determined by the same set of jurisdiction characteristics. The endogeneity corrected estimates, which rely on instruments motivated by the theoretical model, suggest stronger responses to tax rates than the uncorrected estimates in both this paper and the existing literature. The second insight involves the appropriate unit of observation. The empirical literature has conducted both aggregate analyses, in which jurisdictions are the unit of observation, and discrete choice analyses, in which manufacturing plants are the unit of observation. While the tax competition model demonstrates the violation of a key assumption in discrete choice analyses, the estimating equation in this paper, an aggregate analysis, can be derived directly from the model. Third, the theoretical model sheds light on the appropriateness of previously employed measures of tax burdens. The effective tax rate is shown to be superior to the after-tax rate of return, which is both invariant across jurisdictions and dependent on the distribution of investment. Fourth, this paper provides estimates of the degree of undertaxation of capital, which has been the focus of the theoretical tax competition literature but has yet to be addressed empirically. These estimates suggest that the efficient revenues may be as much as two times the size of actual revenues.

Keywords: Tax competition, fiscal federalism, state and local public finance

Full paper (234 KB PDF)

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Last update: December 23, 2002