State Tax Competition for Foreign Direct Investment: A Winnable War?

When a multinational firm invests in a country, potential host states compete for the firm by offering firm-specific tax reductions. Critics blast such incentives as a prisoner’s dilemma that transfers rents to the firm without affecting the investment decision. In fact, these incentives are tied to the firm’s use of domestic inputs indicating that incentives affect output decisions. If there exist positive interstate spillovers, a federal subsidy is necessary to reach the national optimum without tax competition. Competition reduces state taxes and thus the need for federal subsidies. Also, under competition, the firm locates in the nation’s preferred location. Therefore, tax competition offers two means of increasing national welfare, indicating that it is not a simple prisoner’s dilemma.