On the timing of tax and investment in fiscal competition models

We study a model in which asymmetric regions compete for capital with both public investments and taxes. Public investments are chosen in the first stage, and then source income taxes are set in the second stage. Public investments increase the productivity of capital and they also serve to stake out a positive advantage in the tax competition stage. In standard theories of tax competition, investments and taxes were assumed to be chosen simultaneously. Comparing our approach to earlier theory, we show that regions prefer to choose investment before taxes. We also show that sequential choice of taxes is preferable to simultaneous choice of taxes, and that modulo sufficient asymmetry among regions, the simultaneous choice of investment is preferable to the sequential choice of investments. Our theoretical prediction is that both taxes and public investments are distorted downwards in equilibrium.