for a survey). There are also several contributions analyzing intergovernmental
competition in corporate tax rates with firm mobility (Boadway, Cuff & Marceau
(2002), Fuest (2005)). But, to the best of our knowledge, this contribution is
the first to investigate the optimal structure of the corporate tax system in the
presence of firm mobility in a formal model. We analyze this question in a general
framework, where firms differ in profitability and mobility costs. The government
may use the tax base and the tax rate as policy parameters. We show that the
mobility of firms across borders does create incentives for governments to deviate
systematically from investment neutrality. The optimal policy depends on how
profitable mobile firms are, relative to immobile firms. If the marginal mobile firm
is more profitable than the average firm in the country, a tax rate cut cum base
broadening policy is optimal. The reason is that this policy redistributes the tax
burden from mobile to immobile firms. Thus, mobile firms can be prevented from
leaving the country without losing too much tax revenue. But if the marginal
mobile firm is less profitable than the average firm in the economy, a tax rate cut
cum base broadening policy reduces welfare. In this case, the optimal tax policy
consists of subsidizing the normal return to capital and increasing the statutory
tax rate.
The remainder of the paper is organized as follows: In section 2, we present a
very simple two firm model which clarifies our argument and the intuition. Section
3 provides a more general model where we analyze a continuum of firms differing
in profitability and mobility and refine the results derived in the previous section.
In section 4 we discuss the implications of our results and conclude.
2 Optimal tax policy in a two mobile firm setting
Consider an economy with only two mobile profit-maximizing firms, which are
owned by some domestic residents. Both firms differ in profitability. Profitability
depends on firm-specific characteristics, called A, and location-specific character-
istics, called B. Both firms invest in capital K, which is provided by a world
capital market, and receive income of F
with i = 1,2.
The produc-