Dynamic Tax Competition, Home Bias and the Gain from Non-preferential Agreements

In a dynamic two-period model of tax competition, where an investor has home bias for the country where he/she invests in the initial period, we show that tax revenue under a non-preferential taxation scheme is strictly higher compared to a preferential taxation scheme. A non-preferential taxation scheme not only increases tax revenue in the later period, it also reduces competition in the initial period. The gain from having a non-preferential regime is strictly increasing in home bias as long as home bias is not large enough. When home bias is above a critical level, the gain from having a non-preferential agreement is independent of home bias. While the literature on tax competition has identified that ``home bias" can make non-preferential taxation preferable to a preferential regime when investors are small with heterogeneous home bias, we show that even when investors are large with a discrete home bias, a non-preferential regime generates higher tax revenue compared to a preferential regime. We show that even when only one of the capital bases has home bias, a non-preferential regime generates higher tax revenue compared to a preferential regime. This paper also quantify the gain from a non-preferential regime with a parameter which captures home bias and provide clear comparative statics. Moreover, we also show that a country has an incentive to unilaterally commit to a non-preferential agreement.