Fiscal Competition, Revenue Sharing, and Policy-induced Agglomeration

Revenue sharing can be used to discourage low tax regions from competing for capital and firms with high tax regions. However, with heterogeneous regions, revenue sharing involves net transfers across regions and creates a “moral-hazard” problem – that is, regions may want to invest less in market fostering public good when the benefits are shared across nations. This paper analyzes these costs and benefits of revenue sharing. When asymmetric regions compete in capital income taxes only, we show that revenue sharing can be desirable for the high tax region if it is pushed far enough (i.e., J-curve effect), while tax harmonization is always harmful for the low tax region. When regions also compete through public investments, we find that tax competition distorts (downwards) public investments. While revenue sharing discourages public investments due to moral-hazard effect, it remains beneficial in most cases. Moreover, there are new agglomeration forces resulting from public investments, because the inflow of capital raises the incentive for public investments which in turn attract more capital. This leads to the possibility of policy-induced agglomeration (which is different from the classical agglomeration forces in the New Economic geography). JEL Classification: C72, H23, H70.