Asymmetric international transport costs and tax competition: the influence of a third country

The purpose of this paper is to investigate the influence of a third country on the location of foreign direct investment (FDI). We focus on two determinants of FDI location. The first is the number of firms located in the third country. The second is the magnitude of demand for the good that the investing firm produces. We construct a three-country model, where two of the three countries are potential host countries and one has a geographic advantage in exports to the third country. Using this framework, we show that when the number of firms in the third country is sufficiently large, the farther (more distant) country is always the location of the plant. Furthermore, when the market size of the third country is large, it is possible for the nearer country to be the host country. In addition, we find that when the governments of the potential host countries use taxes or subsidies to attract FDI, the location of the firm investing is qualitatively the same as that without tax competition. However, the range over which the nearer country can attract the investing firm when tax competition is introduced is wider than otherwise. Finally, we reveal that when two potential host countries form a union that imposes a coordinated tax, the aggregate welfare of the union under the coordinated tax policy is higher than that under tax competition. However, conflict between the two countries may occur when the number of rival firms in the third country is neither too small nor too large.