The effect of agglomeration size on local taxes

Standard tax competition models predict a ‘race-to-the-bottom’ of corporate tax rates when firms are mobile. Recent theoretical literature shows that central regions with large clusters of economic activity are able to set positive tax rates without fear of losing firms to peripheral regions as the firms would forego ‘rents’ from agglomeration economies. We study whether local policy makers effectively tax such agglomeration rents. We test this with data from Swiss municipalities. We find that municipalities in large urban areas indeed set higher tax rates than those in small ones. Within urban areas, however, municipal tax rates are unrelated to the size of economic activity in and around municipalities while they are positively related to the size of the political jurisdiction. We see this result as evidence that the standard tax competition model for asymmetric jurisdictions is at work in the competition of municipalities within an urban area.