1 Introduction
A sizeable literature in theoretical public finance argues that the location of
capital in general and that of multinational enterprises (MNEs) in particular
reacts sensitively to profit tax policy (Wilson, 1987; Janeba, 1995; Huizinga
and Nielsen, 1997; Haufler and Wooton, 1999; Wilson, 1999; Ludema and
Wooton, 2000; Davies, 2003, 2005; Devereux and Hubbard, 2003; Baldwin
and Krugman, 2004; Raff, 2004; Borck and PflUger, 2006; Bucovetsky and
Haufler, 2008; by no means, this list is exhaustive). When lumpy investment
- i.e., firm or plant location - is sensitive to profit taxation, many of these
models predict a race to the bottom in profit tax rates so that, in equilibrium,
countries have to offer a profit tax rate of zero to attract investors. Otherwise,
a jurisdiction will lose the whole profit tax base to its competitors. One key
reason for this outcome is that - in most of the traditional models of tax
competition - countries differ only in terms of profit taxes or, more precisely,
low profit taxes are the only attraction governments may offer to firms.
Empirically, there is hardly any evidence of a race to the bottom in profit
taxes (except for the existence of a few small tax havens). Therefore, recent
theoretical work suggested mechanisms to avoid the knife-edge case of a race
to the bottom in tax rates. The New Economic Geography literature hy-
pothesizes that there are factors generating agglomeration economies which,
in turn, reduce the sensitivity of location decisions of foreign MNEs with
respect to profit (or capital) taxation (Ludema and Wooton, 2000; Baldwin
and Krugman, 2004; Borck and PflUger, 2006). More generally, taxes are
only one factor affecting firm location. There is little reason for a munici-
pality to eliminate profit taxes provided that the overall environment - e.g.
available infrastructure and human capital endowment of the work force -
makes it attractive enough to locate there.
It is by now well documented in empirical research at various levels of
aggregation (firms, industries, and aggregate bilateral activity) that the lo-
cation of MNE activity across countries inter alia depends on national profit
tax policy (Devereux and Griffith, 1998; de Mooij and Ederveen, 2003, 2006,
2009; Blonigen and Davies, 2004; Grubert and Mutti, 2004; Huizinga and
Nicodeme, 2006; Egger, Pfaffermayr, Loretz, and Winner, 2008; Overesch
and Wamser, 2008). However, there are two concerns with previous work.
First, for some countries, such as Germany or Switzerland, the (unique)
profit tax rate is an artifact, since tax authorities at the sub-national level
may determine taxes on profits in their jurisdiction. Second, countries differ