Industrial agglomeration and capital taxation

Abstract

Models with imperfect competition and intra-industry trade have become widely accepted as appropriate frameworks within which to analyze the impact of trade liberalization on industrial agglomeration. This paper makes one modi…cation to the standard model; it allows for taxation of internationally mobile capital. Making this change fundamentally alters the main lesson from the tax literature that a country which faces perfectly internationally mobile capital should not use source-based taxes on capital income. In particular, it is shown that a country which hosts an agglomeration may actually increase its welfare level per capita by levying a source-tax on capital income even if capital can move costlessly between countries. It is thereby able to exploit the locational inertia created by agglomeration forces.