DP6606 | Do Agglomeration Economies Reduce the Sensitivity of Firm Location to Tax Differentials?

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Low corporate taxes can help attract new firms. This is the main mechanism underpinning the standard 'race-to-the-bottom' view of tax competition. A recent theoretical literature has qualified this view by formalizing the argument that agglomeration forces can reduce firms' sensitivity to tax differentials across locations. We test this proposition using data on firm startups across Swiss municipalities. We find that, on average, high corporate income taxes do deter new firms, but that this relationship is significantly weaker in the most spatially concentrated sectors. Location choices of firms in sectors with an agglomeration intensity at the twentieth percentile of the sample distribution are estimated to be twice as responsive to a given difference in local corporate tax burdens as firms in sectors with an agglomeration intensity at the eightieth percentile. Hence, our analysis confirms the theoretical prediction: agglomeration economies can neutralize the impact of tax differentials on firms' location choices.