Heterogeneous Firms, `Profit Shifting‘ FDI and International Tax Competition

Abstract

We develop a stylized model of international tax competition between a large country and a tax haven. In the large country, firms in a monopolistically competitive industry generate positive profits which can be taxed by the government. Firms have heterogeneous productivity levels and can choose to undertake ‘profit shifting’ FDI in order to benefit from lower tax rates abroad. We find that economies with a low degree of firm heterogeneity and a high degree of monopolistic market power are less affected by international tax competition. They face lower outflows of the tax base and can set higher tax rates.