Localization Economies and the Sensitivity of Firm Foundations to Changes in Taxation and Public Expenditures

This paper investigates the influence of tax rates and public expenditures on the number of firm foundations in West German municipalities in the presence of localization economies. Brülhart et al. (2012) use Swiss data to show that localization economies can mitigate the negative effects of taxation on firm foundation rates. Firms are more willing to accept higher tax rates if localization economies within their industry exist that generate beneficial spillover effects. These agglomeration rents can be taxed by municipalities (see Koh et al. 2013) and localities can use additional revenues for public spending. This work exploits information on the localization of German industries on a 2 digit level based on work by Koh and Riedel (2014). It is combined with detailed data on the number of firm foundations, the local business tax rate and public expenditures in West German municipalities to analyze the sensitivity of firm foundations to changes in the local tax rate and public spending with respect to localization economies. Similar to Brülhart et al. (2012) the results for Germany imply that increasing localization of an industry diminishes the negative effect of business taxation at a given location. On top, the results show that the positive effect of public expenditures (namely economic promotion and municipalities total capital stock) is mitigated by localization economies.