Fiscal competition and offshoring

This paper analyses fiscal competition between two countries in a model where firms operating in imperfectly competitive markets may offshore their production to a low-cost third country. We show that this kind of cost-induced offshoring may have two externalities on the other country's welfare. Firstly, consumer surplus increases due to lower prices, and secondly, profits and thus profit tax revenue decrease in response to lower prices. We demonstrate that the latter effect may dominate the former. This implies that offshoring may have a negative externality. Since higher taxes in high cost countries increase offshoring, tax competition may lead to inefficiently high tax rates. High cost countries may benefit from a coordinated reduction of their corporate taxes.