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Local Corporate Taxes Have Only Weak Effects On Business Location Decisions

A local authority that cuts business taxes by one percentage point increases the probability that a new business will locate in their area (rather than in a neighbouring area) by just one percentage point. That is the central finding of
new research by Roland Rathelot and Patrick Sillard, which looks at the impact of corporate tax rates on business location decisions across the more than 36,000 municipalities in France.

Their study, which is published in the March 2008 issue of The Economic Journal, suggests that any ''race to the bottom'' – where neighbouring councils compete for businesses to locate in their area by lowering tax rates – would
be costly and unproductive. It also suggests that local business taxes are not the best instrument for reviving depressed areas of a country.

Many countries are divided into local authorities that are allowed to raise their own corporate tax, imposed on all businesses set up in the area. These local authorities may compete with each other to attract economic activity.
The question explored in this research is to what extent businesses are sensitive to the level of the corporate rate in their location decisions. The study looks at data for France, where the national territory is split into
36,600 municipalities.

Establishing the effect of the corporate tax rate on the location decisions of businesses is not as simple as it seems. Taxes are not the only factor influencing where firms locate. For example, firms typically prefer to locate near other firms since transport and communication networks are likely to be good, and there is a pool of trained workers available to employ. So areas with many firms may be able to have higher taxes than other areas, as firms
benefit more from basing themselves there.

To isolate the pure effect of the corporate tax on business location decisions, the authors look at municipalities located along the boundaries of departments. Departments are bigger local authorities, containing around 400
municipalities each, and allowed to raise their own corporate tax. Because department are huge compared with municipalities, their tax decisions are not affected by local situations.

Because municipalities are very small (around four kilometres in diameter), it is reasonable to think that the environment facing two neighbouring municipalities only separated by a department boundary is very close. The
idea is thus that the difference between the situations of these two municipalities is only driven by the difference in the corporate tax rate fixed by the departments.

The results of this study have important implications for policy-making. First, it suggests that any ''race to the bottom'' between local authorities would be costly rather than efficient. The national regulator may be keen to prevent local authorities from abusing this tool.

Second, in some cases, like in distressed areas, spatial inequalities might have some unlikely consequences in terms of both economic and social outcomes. This could induce the national government to try and remedy
spatial unbalances. This study suggests that, used alone, local corporate taxes are not an efficient instrument.

''The Importance of Local Corporate Taxes in Business Location Decisions: Evidence from French Micro Data'' by Roland Rathelot and Patrick Sillard is published in the March 2008 issue of The Economic Journal.