Keywords: Tax competition, fiscal federalism, state and local public finance
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.
Full paper (234 KB PDF)
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Last update: December 23, 2002