Tax and the city — A theory of local tax competition

•Our sequential tax competition model accounts for spatial properties of competition.•Large and small cities compete with a different set of competitors for mobile capital.•The model is motivated by recent empirical work and survey evidence from Germany.•Capital taxes of large cities fall more strongly with higher interregional competition.•This may eventually lead to smaller taxes in larger jurisdictions.

In this paper we propose a novel theoretical model of tax competition at the local level. Large jurisdictions (cities) compete both locally with smaller neighbouring communities and interregionally with more distant cities, while small jurisdictions (hinterlands) compete only with other jurisdictions in their neighbourhood. The model structure is motivated by recent empirical findings as well as survey results among German mayors: the perceived intensity of competition for firms varies considerably between jurisdictions and can mainly be explained by the size and location of the jurisdiction. Our model predicts – contrary to earlier findings for competition between countries or regions – that capital taxes of large jurisdictions fall more strongly with increasing interregional competition and may eventually lead to smaller taxes than in small jurisdictions. Hinterlands are therefore less affected from globalisation than cities. We contrast our results with a standard tax competition model in which all jurisdictions compete with all other jurisdictions.