Firm clusters and government: Who taxes whom?

Marius Brülhart, Helen Simpson 12 June 2015

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In a world in which capital can be moved across borders with ever greater ease, governments may find it increasingly difficult to raise revenue from capital income, forcing them instead to shift the burden to less mobile tax bases. Such intensifying capital tax competition is one of the reasons behind Piketty’s (2014) famously gloomy predictions for the evolution of inequality in the 21st century.

Theories on government taxation and agglomeration

A prominent qualifier to the ‘race-to-the-bottom’ story of capital taxation, however, has been raised, among others, by Baldwin and Krugman (2004), who found that agglomeration or clustering forces may make firms less footloose than one might think. Indeed, according to their line of argument, governments of jurisdictions that host industry clusters can extract a fiscal rent from their de facto immobile tax base up to the point where they can just hold on to the cluster in the face of low-tax competitors.

The existing evidence on whether governments actually tax agglomeration rents suggests that observed tax rates are indeed higher in places that are host to an agglomeration or that feature a higher density of economic activity. Buettner (2001), for example, found that more populous German municipalities set higher local business tax rates, and Charlot and Paty (2006) have documented that French municipalities with greater access to markets set higher business tax rates. More recent analyses have sought to overcome the empirical problem that the direction of causation between local taxes and the clustering of firms may run in both directions (see e.g. Luthi and Schmidheiny 2014). These studies also find that agglomerations are associated with high taxes.

Clusters of firms could, however, have the exact opposite effect on local taxation if rather than having some of their agglomeration benefits taxed away by the government, they instead were able to exploit their bargaining position in order to obtain favourable treatment from the government. The political-economy literature points to such ‘policy capture’ as being stronger at the local than at the national level. It shows why incumbent declining firms and industries may expend greater lobbying effort than entrants, and suggests that geographically concentrated industries are particularly active in seeking to influence policy.

New evidence

In Brülhart and Simpson (2015), we pit these alternative theories against each other, and examine whether and how government policy reacts to the presence of industrial agglomerations. We analyse the generosity of a major place-based subsidy scheme in the UK which aimed to induce firms to locate jobs in economically lagging and mostly remote regions, that is, typically away from existing clusters. Subsidies can be thought of as negative taxes. We ask whether government pays more or less generous per-job subsidies to plants in more agglomerated industries, and how the subsidy rate in such industries varies with geographic distance to existing industry employment. In addition, we explore how subsidy offers vary with the jurisdictional tier of policymaking, with the degree of area-industry specialisation, and with the characteristics of applicant firms – all complementary ways of assessing the policy capture predictions of political-economy models.

We find some evidence that firms in more agglomerated industries both ask for and receive higher per-job subsidies, but no evidence that this increases in locations more remote from the bulk of industry employment, as would be predicted by theories which emphasise that governments can tax (or offer lower subsidies to) clusters. However, when distinguishing between different jurisdictional tiers, our results suggest that decentralised, local government authorities appear to be structuring their offers so as to favour, and try to preserve, existing employment in more agglomerated industries in those areas with a higher concentration of industry employment.

  • That is, conditional on the amount applied for by firms, governments offer more generous subsidies in more agglomerated industries in areas with a higher density of industry employment.

This phenomenon furthermore is most pronounced in areas where employment in the respective industry is in relative decline.

  • Taken together, these results are consistent with theories of ‘policy capture’ by predominant incumbent local industries, rather than government taxation of agglomeration benefits.

In principle, the finding that subsidies offered by lower-tier authorities are more generous in areas that host an industry cluster could have another explanation. Local jurisdictions could be using subsidies to attract plants that might themselves generate significant agglomeration benefits for the area, and such external benefits could be more pronounced in locations that are already relatively specialised in an applicant’s industry (see, for instance, Greenstone et al. 2010). However, this seems unlikely to apply to the research setting used in Brülhart and Simpson (2015). Agglomeration benefits running from plants applying for grants to existing firms in the surrounding area are likely to be relevant for large projects. Hence, this plausibly holds in the case of the ‘million dollar plants’ studied by Greenstone et al. (2010), who found that new entrants do generate significant benefits for incumbent firms. In the British policy setting, where the projects at stake are on average some two orders of magnitude smaller, this is not a plausible mechanism. Our finding that the more generous grant offers are made to incumbent plants applying to safeguard existing jobs but not to entrants creating new jobs reinforces the conclusion that government capture is the more likely mechanism than prospective cluster building.

Our results are reminiscent of prior findings whereby subsidy policies ostensibly targeted at growth sectors in fact are geared towards industries and regions in relative decline (Beason and Weinstein 2005, Martin et al. 2011), and they support the view that the optimal degree of fiscal decentralisation is contingent on the extent to which policy may be subject to capture by dominant entrenched local interests (Bardhan 2002).

Concluding remarks

What does this research contribute to the policy debate? In terms of local-level fiscal policymaking, capture by incumbent industry clusters, as argued by Glaeser (2002), is “the only theory that suggests that tax incentives would create spatial distortions”. Hence, decentralising fiscal powers will be less economically efficient the greater the scope for local policy capture.

In terms of the broader discussion about capital tax competition, our results point to a world in which agglomeration forces, rather than acting as a break on the race to the bottom, further tilt the playing field to the advantage of capital. When mobile, firms can shop around for the lowest taxes, which in turn will force governments to lower their tax rates; and when immobile, (large or clustered) firms seem to enjoy a particularly strong hand in negotiating with local governments. Put somewhat differently, since agglomeration forces have been shown to apply mostly at a relatively small spatial scale (Rosenthal and Strange 2004), they may have little impact on international tax competition but affect taxation at the subnational level – to capital’s advantage if policy capture is the dominant force.

This is, of course, a strong and possibly overdrawn conjecture. More research on the strategic interactions between national and local tax authorities on the one hand, and spatially agglomerated industries on the other hand, is clearly called for.

References

Baldwin, R E and P Krugman (2004), “Agglomeration, Integration and Tax Harmonisation”, European Economic Review, 48(1): 1-23.

Bardhan, P (2002), “Decentralization of Governance and Development”, Journal of Economic Perspectives, 16(4): 185-205.

Beason, R and D E Weinstein (2005), “Growth, Economies of Scale, and Targeting in Japan (1955-1990)”, Review of Economics and Statistics, 78(2): 286-295.

Brülhart, M and H Simpson (2015), “Agglomeration Economies, Taxable Rents, and Government Capture: Evidence From a Place-Based Policy”, CEPR Discussion Paper 10578.

Buettner, T (2001), “Local Business Taxation and Competition for Capital: The Choice of the Tax Rate”, Regional Science and Urban Economics, 31(2-3): 215-245.

Charlot, S and S Paty (2007), “Market Access Effect and Local Tax Setting: Evidence from French Panel Data”, Journal of Economic Geography, 7(3): 247-263.

Greenstone, M, R Hornbeck and E Moretti (2010), “Identifying Agglomeration Spillovers: Evidence from Winners and Losers of Large Plant Openings”, Journal of Political Economy, 118 (3): 536-598.

Luthi, E and K Schmidheiny (2014), “The Effect of Agglomeration Size on Local Taxes”, Journal of Economic Geography, 14(2): 265-287.

Martin, P, T Mayer and F Mayneris (2011), “Public Support to Clusters: A Firm Level Study of French ‘Local Productive Systems”, Regional Science and Urban Economics, 41: 108-123.

Piketty, T (2014) Capital in the Twenty-First Century, Harvard University Press.

Rosenthal, S and W Strange (2004), “Evidence on the nature and sources of agglomeration economies”, In: Henderson, J V, Thisse, J-F (Eds.), Handbook of Regional and Urban Economics, Vol. 4. Elsevier, Amsterdam.

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Topics:  Industrial organisation Taxation

Tags:  agglomeration, capital taxation, clusters, local capture

Professor of Economics, University of Lausanne; Research Fellow, CEPR

Reader in Economics, University of Bristol; Director, Centre for Market and Public Organisation

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