Tax competition for foreign direct investment

We analyze tax competition between two countries of unequal size trying to attract a foreign-owned monopolist. When regional governments have only a lump-sum profit tax (subsidy) at their disposal, but face exogenous and identical transport costs for imports, then both countries will always offer to subsidize the firm. Furthermore, the maximum subsidy is greater in the larger region. However, if countries are given an additional instrument of either a tariff or a consumption tax, then the larger country will no longer underbid its smaller rival and its best offer may involve a positive profit tax. In both cases the equilibrium outcome is that the firm locates in the larger market, paying a profit tax that is increasing in the relative size of this market and which is made greater when the tariff (consumption tax) instrument is permitted.