Public goods, unemployment and policy coordination

Earlier literature on tax competition and policy coordination typically assumes that the labor market is competitive; a description less suitable for Europe, where trade unions have had a strong position in the labor market for a long time. This paper concerns factor income taxation and public good provision in small open economies characterized by capital mobility and imperfect competition in the labor market. We assume that each national government collects public revenues via taxes on capital and profit income, and that the revenues are spent on a public consumption good and a public input good, where the latter enters the economic system in terms of an 'externality production factor'. We show that tax coordination contributes to higher welfare even if the labor market is noncompetitive. However, the relative overprovision of the public input good derived by Keen and Marchand [Keen, M., Marchand, M., 1997. Fiscal competition and the pattern of public spending. Journal of Public Economics 66, 33-53.] may no longer hold in the presence of unemployment.