Tax and the City - A Theory of Local Tax Competition and Evidence for Germany

In this paper we use survey responses of mayors from cities and municipalities in the German state of Baden-Württemberg to study the "true" spatial structure of local tax competition. The size of the jurisdiction and, in particular, its economic function turn out to be the important determinants of the decision-maker’s perception of the intensity of competition. In particular, respondents from urban centres perceive a much higher intensity of competition for firms with respect to competing jurisdictions which are distant or even located in other countries. Our empirical findings confirm the assumption of the empirical literature about the importance of neighbourhood competition, but it also shows that another important factor is missing. In particular, the assumption of the empirical literature that competition takes place only among neighbours is at odds with the theoretical approaches where all jurisdictions compete simultaneously. The existing standard models, however, are incapable of explaining the empirical particularities of local competition.

These empirical findings motivate our sequential tax competition model which considers a rich competition structure. Essentially, we assume a number of metropolitan regions which each consist of one city centre and a number of surrounding (rural) jurisdictions. The model has two levels of competition for mobile capital: first, cities simultaneously compete for mobile capital by setting their tax policies (which can be interpreted as competition for large scale investments, such as headquarters); second, rural areas compete simultaneously for capital within their metropolitan area (which corresponds to the neighbourhood competition).

We are especially interested in the effects of a rise in the number of metropolitan regions, which represents the increase in external competition, for example through globalisation, Eastern enlargement of the EU or German unification. It is shown that – similarly to standard models – the capital tax rates of the cities converge to zero, but they stay positive for the hinterlands. Moreover, cities are more affected by an increase in external competition than hinterlands, since they reduce capital tax rates more and shift more from mobile capital to immobile labour taxation. In contrast to existing models, our results imply that larger jurisdictions do not necessarily rely more on capital taxes in case they face strong competition with more distant competitors. Based on tax data from Baden-Württemberg, we show that several of the predictions from the sequential model are in line with the development of tax rates in the past 20 years.

Janeba, Eckhard and Steffen Osterloh (2012), Tax and the City - A Theory of Local Tax Competition and Evidence for Germany, ZEW Discussion Paper No. 12-005, Mannheim.