Tax competition in imperfectly competitive markets

The literature on strategic trade policy has shown that in imperfectly competitive markets governments have an incentive to subsidize exports of their own firms. Yet the consequence of the departure from laissez-faire is a wasteful subsidy race. In contrast, this paper shows that even in imperfectly competitive markets there is a strong tendency for laissez-faire to prevail. The driving force is the firms' willingness to exploit tax or subsidy differentials by relocating production. A small tax differential induces firms to change their place of production. The change in market structure has a negligible effect on the oligopoly equilibrium, but a non-negligible impact on government revenues. When tax policy is non-discriminatory, governments gain (lose) by attracting all firms when production is taxed (subsidized). Hence, laissez-faire is the only equilibrium. Since, from the point of view of the two producing countries, laissez-faire (nondiscrimination) Pareto dominates the intervention equilibrium (discrimination), nondiscrimination is a simple device to result in a mutual beneficial outcome. (C) 1998 Elsevier Science B.V.