Keep Your Friends Close and Your Enemies Closer: Network externality and tax competition

This study investigates the effects of network externality on the policy competition between two countries regarding their attempts to attract a multinational enterprise (MNE). The two countries have different numbers of consumers and endogenously set a tax/subsidy on the MNE. The larger country has a local firm with a large market. Network externality makes the larger country with the local firm more attractive to the MNE because the resulting larger supply amplifies the network size. The MNE's location in the larger country can also benefit the local firm despite fiercer competition with the MNE while also benefiting consumers in all countries. Fiscal competition increases the likelihood of a larger country hosting the MNE when the network externality is large, but it promotes the MNE's location in a small country when the network externality is small. A location change from a smaller to a larger country, induced by fiscal competition, improves both countries' welfare or their joint welfare when the network externality is significant.