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This paper investigates the impacts of capital mobility and tax competition in a setting with imperfect matching between firms and workers. The small country attracts less firms than the large one but accommodates a share of the industry that exceeds its capital share—a reverse home market effect. This allows the small country to be more aggressive and to set a higher tax rate than the large one, thus implying that tax competition reduces international inequalities. However, the large country always attains a higher utility than does the small country. Our model thus encapsulates both the “importance of being small” and the “importance of being large”. Last, tax harmonization benefits to the small country but is detrimental to the large one.

During the last two decades, OECD countries have experienced very high increases in foreign direct investments (OECD, 2003). As economic integration gets deeper, these investments are likely to become more responsive to differentials in corporate tax rates. The empirical evidence collected by Mooij and Ederveen (2003) confirms the idea that governments vastly use such an instrument to influence firms’ locational choices. Building on that observation, the literature on fiscal competition studies how governments choose their tax rates in order to attract firms (Wilson, 1999). Because the outcome of fiscal competition crucially hinges on the international mobility of capital, it seems promising and reasonable to build on the microeconomic underpinnings of firms’ locational choices. New economic geography (NEG) aims precisely at explaining how firms do interact to form clusters within a few regions (Fujita et al., 1999 and Baldwin et al., 2003). It is, therefore, natural to tackle the process of fiscal competition by using the main ingredients of NEG, namely increasing returns, market size, and imperfect competition.

We have obtained new results in tax competition in an otherwise standard model, which goes back at least to Salop (1979). Whereas the large country has more firms per capita than does the small country both under tax competition and tax cooperation in Ottaviano and van Ypersele (2005), we have seen that the large country always exports capital toward the small one. This is because we have a RHME, whereas the home market effect holds in Ottaviano and van Ypersele. This shows that the way firms choose their location is crucial in assessing the merits of tax competition. Stated differently, uncovering the various mechanisms that drive the mobility of firms across countries is needed to understand the possible implications of fiscal competition