Policy Competition in a Spatial Economy 

Abstract

This paper provides a new framework to measure the interactions between strategic governments and their impacts on economic outcomes in a spatial general equilibrium economy. This framework is used to quantify the welfare implications of strategic tax decisions. The degree of tax competition is quantified by deriving an endogenous Policy Network Matrix which generalizes the exogenous postulated weight matrix postulated in prior literature. We develop a spatial general equilibrium model with endogenous commodity tax competition. We apply our model to U.S. county sales taxes which allows us (1) to measure the interjurisdictional price incidence of local taxes, (2) to quantify the different components of local governments’ tax rules, and (3) to investigate the welfare effects of various tax reforms like the introduction of a minimum tax or the imposition of tax harmonization. At the observed equilibrium, the Policy Network Matrix suggests an average tax competition effect or tax reaction slope of 9% which can be decomposed into a positive reaction of 10.2% to 22% of a county’s neighbors, a small negative reaction of -1.2% to 78% of its neighbors. The overall tax exposition of U.S. counties to tax competition is similar. However, their policy impacts on other counties is strikingly heterogenous with only a few large counties facing small competitors having a significant impact. We also measure that a minimum tax reform generates an average positive welfare effects of which is reduced by 5% due to tax competition.