Keep Your Friends Close and Your Enemies Closer: Network Externality and Tax Competition

Abstract
This study investigates the effects of network externality on two countries’ policy competition to attract multinational enterprises (MNEs). The two countries have different numbers of consumers and endogenously set a tax/subsidy on an MNE. There is a local firm in a country with a large market. The network externality makes the larger country with the local firm more attractive to the MNE because the resulting larger supply amplifies the network size. The MNE’s location in the larger country can benefit the local firm despite fiercer competition with the MNE and also benefit consumers in all countries. Fiscal competition increases the likelihood of a larger country hosting the MNE when the network externality is large, but it promotes the MNE’s location in a small country when the network externality is small. A location change from a smaller country to a larger country, induced by fiscal competition, improves the welfare of both countries or their joint welfare when the network externality is significant.

This is joint work with Hiroshi Mukunoki.