Tax Competition and the Efficiency of “Benefit-related” Business Taxes

We construct a tax competition model in which local governments finance business public services with either a source-based tax on mobile capital, such as a property tax, or a tax on production, such as an origin-based Value Added Tax, and then assess which of the two tax instruments is more efficient. Many taxes on business apply to mobile inputs or outputs, such as property taxes, retail sales taxes, and destination-based VATs, and their inefficiency has been examined in the literature; however, proposals from several prominent tax experts to utilize a local origin-based VAT have not been analyzed theoretically. Our primary finding is that the production tax is less inefficient than the capital tax under many — but not all — conditions. The intuition underlying this result is that the efficiency of a user fee on the public business input is roughly approximated by a production tax, which applies to both the public input and immobile labor (in addition to mobile capital). In marked contrast, the capital tax applies only to mobile capital and is thus likely to be relatively inefficient.