Policy Competition in a Spatial Economy
Abstract
We add endogenous policies and strategic interactions among governments to a spatial general equilibrium economy. The interdependence of policymaking among a network of counties in
the USA is characterized by 3109×3109 endogenous bilateral linkages. These linkages are summarized in a novel metric: policy impact is the effect a jurisdiction changing its tax rate on the rest of the world. Unlike the prior reduced-form literature with exogenous linkages, policy impact is heterogeneous across jurisdictions and the primary driver of the welfare effects of tax competition. Applying the model to local sales taxes in the USA and introducing minimum local tax rates, we document (1) strategic interactions and the welfare effects of tax competition are extremely heterogeneous and even opposite signed across jurisdictions, (2) omitting endogenous policies from a spatial GE economy will result in ignoring 6.4% of the true welfare effects, and (3) that policy impactnot the previously studied reaction function slope that captures the exposure to policy changesis what drives the welfare effects of tax competition. Using counterfactual analysis, we show that welfare can be improved
by forcing high policy impact jurisdictions to raise their tax rate rather than targeting lowtax jurisdictions, as if often done with a minimum tax rate. Although policy impact is an endogenous concept, we document that jurisdiction size alone acts as a strong proxy.
