Locational competition and Agglomeration: The Role of Government Spending

With the completion of EMU, tax competition and, more in general, locational competition is high on the EU policy agenda. In contrast to the standard neo-classical reasoning, recent advances in the theory of trade and location have shown that tax competition does not necessarily lead to a ‘race to the bottom’. In these recent discussions the relevance of government spending as an instrument for locational competition is unduly neglected. We therefore introduce a more elaborate government sector in a geographical economics model by analyzing government spending and government production. By changing the relative size, direction or efficiency of the production of public goods, our simulation results show that governments can change the equilibrium between agglomerating and spreading forces. In addition, we show analytically that the introduction of public goods fosters agglomeration. Ultimately, our paper shows that by restricting attention to taxes, one ignores that government spending also determines the attractiveness of a country as a location for the mobile factors of production. JEL Code: H10, F12, F15 *Respectively, Department of Economics, University of Groningen and CESifo; Utrecht School of Economics, Utrecht University and CESifo; Department of Economics, Erasmus University. A first draft of this paper was written during a stay at CESifo, Center for Economic Studies, University of Munich. We would like to thank Gianmarco Ottaviano and Jan Egbert Sturm for their help, some participants of the 2002 EEA conference in Venice for their useful comments, and CESifo for its hospitality. Send all correspondence to: [email protected], Dept. of Economics, University of Groningen, PO Box 800, 9700 AV Groningen, The Netherlands.