Tax Competition for International Producers and the Mode of Foreign Market Entry

This paper studies tax competition between two countries for an international producer. The international producer chooses where to locate its headquarters and whether to serve the overseas market through exports or foreign direct investment (FDI) and local supply. We show that, in the absence of tax competition, the international firm may choose FDI even though this has welfare costs from a global point of view. With tax competition, the parent country’s tax is pinned down, allowing the host country to use its tax rate to enforce exporting instead of FDI. This leads to a Nash equilibrium in the tax setting game which is associated with higher world welfare than the no-tax situation. Thus, because of the effect on entry mode, tax competition provides heretofore unexplored benefits.