Formula Apportionment, Tax Competition, and the Provision of Local Goods

The paper develops an analytical framework where regional governments strategically determine the structure of the corporate profit tax system and profits are regionally allocated using an apportionment formula. Two important results emerge in a symmetric Nash equilibrium: (i) investment decisions are distorted, i.e., regional governments will not allow complete deduction of capital costs from taxable corporate profits; and (ii) there is underprovision of the good provided by the regional government, consistent with the literature on property tax competition. The paper also shows that the degree of underprovision may be less severe when the formula employs sales shares to apportion corporate profits. The model allows us to presume that the recent shift by most states in the U.S. towards a formula apportionment that gives a higher weight to the sales proportion may constitute a welfare improvement for all regions, compared to the original formula that weighs all factors equally.