Follow the Leader? Evidence on European and U.S. Tax Competition

This paper contributes to the small empirical literature that attempts to estimate tax reaction functions of national governments competing with other national governments. Our focus is on European countries. After presenting a simple theoretical model, we estimate reaction functions both for a pure Nash model and for a model in which the U.S. can act as a Stackelberg leader while the European countries compete with each other in a Nash way. Our empirical tests provide evidence that European countries set tax rates strategically interacting with their neighbors and following the lead of the United States. In fact, our results suggest that the tax rates of non-tax haven European countries are more responsive to changes in U.S. rates than to their own neighbor’s rates. However, we find no evidence that either the haven or non-haven countries reacted to the tax changes of the United States before 1986, the year of a major U.S. tax reform. We also reject the hypothesis that the countries in our sample have become more competitive in recent years. This is interesting given that our data span the time period during which tax competition is alleged to have become more intense.