DP6186 Competing for Capital When Labour is Heterogeneous

Author(s): Yasuhiro Sato , Jacques-François Thisse

Publication Date: March 2007

Keyword(s): local labour markets , capital mobility , reverse home market effect , fiscal competition

JEL(s): F21 , H31 , J31

Programme Areas: Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP6186.asp.asp

This paper investigates the impacts of capital mobility and tax competition in a setting with imperfect matching between firms and workers. The small country attracts fewer firms than the large one but accommodates a share of the industry that exceeds its capital share - a reverse home market effect. This allows the small country to be more aggressive and to set a higher tax rate than the large one, thus implying that tax competition reduces international inequalities. However, the large country always attains a higher utility than does the small country. Our model thus encapsulates both the 'importance of being small' and the 'importance of being large'. Last, tax harmonization benefits to the small country but is detrimental to the large one.