How important are expectations about future tax policy for firms’ location choice?

There is a great deal of economic research which attempts to identify the effects of the current tax system, and especially the current tax rate, on the behaviour of economic agents. One important issue that has been studied is the impact of the current tax rates on business location choices.

This paper explores whether firms take potential future tax rate changes into account when making their location choice today. This is difficult to evaluate since firms’ expectations about future tax policy are not observed. This research exploits the fact that – once a location decision has been made – governments have the opportunity to tax the resulting business profit at a higher rate the less mobile is
the business (so that it cannot move away to avoid the tax).

By studying a highly immobile firm type – wind turbines – after 2000 in Germany, the research is able to show that German municipalities increased the tax rate on business profits the more wind turbines were located in their jurisdiction. In the second part of the analysis, the research then shows that non-turbine firms were less likely to enter jurisdictions with a high risk of wind turbines entering in the future. This is consistent with the non-turbine firms anticipating a higher tax rate in the future.

The research contributes to our understanding of the impact of tax on business behaviour in two ways. First, it highlights that current tax policy has to be credible to be effective. In the setting examined, governments could not credibly commit not to raise the tax rate in the future. Second, the research highlights that for empirical work the current tax rate is not necessarily a good proxy for business expectations of the future tax rate.

Dominika Langenmayr and Martin Simmler: “Why the current tax rate tells you little: Competing for mobile and immobile firms”, CESifo Working Paper 6904, 2018.