Is International Capital Tax Competition Fueled by the Quest for Increased Productivity?

In this paper we examine the relationship between capital tax competition amongst countries and the productivity spillover effects from foreign capital movements. The traditional theoretical literature regarding tax competition examines the phenomenon through analysis of the competition over tax revenue, which is generated by incoming capital. However, as the theoretical literature on FDI points to improving levels of productivity from managerial and technological spillovers, we investigate the question of whether governments also take into account productivity changes when competing over tax rates. We construct a two country, two firm model incorporating production functions which include productivity spillovers from foreign direct investment. According to our theoretical model, the larger the productivity spillovers from foreign capital, the more intense tax competition will be. We then empirically test this prediction using a spatial dynamic panel data model utilizing a dataset consisting of 42 countries spanning the years of 1998-2012. The empirical model employs system-GMM in order to overcome the endogeneity problem associated with the variables involved in the estimation. We find evidence that productivity levels are having a significant negative impact on tax rates as predicted by the model. Empirical testing is also performed with 21 European Union countries with similar results.