Tax Policy, Location Choices, and Market Structure

A structural model of entry and fiscal policy is presented. It shows that taxation of variable production costs can increase product prices, lower competition, and reduce the availability of new products in small markets. Existing theoretical models of entry and taxation either assume imperfect competition, or monopolists' provision of new goods. Free-entry models help quantifying how cost-reducing shocks affect profitability as a result of the change in market structure relating entry to zero-profits thresholds of equilibrium demand. This paper links imperfect competition models with free-entry models. We study how prices, profits, and entry into concentrated markets change when a tax increasing variable costs of production is eliminated. The theoretical model predicts effects that are comparable to those predicted by theories of cost-reducing technological shocks: new firms enter, commodity prices fall, more customers are being served, and firms' profits increase. The model's test is based on a unique nationwide fiscal experiment: the repeal in 1869 of stamped paper tax and its effect on the on the market structure for daily newspapers in the Netherlands. The econometric analysis uses data on when and where the newspapers existed and were introduced together with demographic census data from 1859 and 1869. The results confirm the model's predictions and show how taxation affects strategic business location decisions. We find that the minimum efficient scale to warrant profitable entry for a monopolist is larger if the tax rate on variable costs of production increases. Given the size of the population, an increase in expected variable profits increases the probability to accommodate manifold firms in the concentrated market place. The results presented in this paper are of general interest and can support any policy related debate about the effects of taxation and entry limitation on profitability, market structures, location choices, development, and the growth of new industries and of emerging markets. Although of historical interest as well and holding true for a specific industry in a small open economy, the study's broader contribution is to better understand the relation between fiscal policy and industrial organization. The 1869 tax reform act stimulated the profitability of firms, encouraged markets to grow, advanced competition, and boosted the development of the young and entrepreneurial industry of daily newspapers. Fiscal policy that suppresses the spread of knowledge to the general public is shown to undermine economic growth, development, and prosperity. After more than 150 years of constitutional freedom of speech the topic of government intervention on the availability of information cannot be of more relevance than today when the new multi-media communication opportunities challenge governments to face the increasing worldwide trade possibilities through internet exchange, and to decide if and how to develop fiscal policies for electronic trade for financing their own future prosperity