Risk sharing and the efficiency of public good provision under tax competition

• This article studies tax competition when corporate taxation serves as insurance.
• Risk sharing may attract investment to high tax regions.
• The corporate tax reduces risk of foreign income.
• The regional corporate tax may be inefficiently low or high due to risk sharing.
• The risk transfer leads to an ambiguous impact of volatility on the corporate tax.

This paper investigates tax competition under uncertainty, when local governments levy a linear source-based tax on corporate income. As the corporate tax transfers part of the risk of investment from firms to the government (risk sharing), two differences to the previous literature arise. First, the capital mobility externality may be positive or negative, depending on how strong the risk sharing effect of taxation is. Second, the sign of the tax exporting externality is also indeterminate. Each government not only exports the burden of taxation, but also bears risk which would have been borne by foreigners instead. Thus, while the socially optimal tax rate equates the risk exposure of the private and the public sectors, the equilibrium decentralized tax may be inefficiently high or low.