Working Papers, Department of Economics, Rutgers, The State University of New Jersey 2002,26
This paper contributes to the small empirical literature that attempts to estimate tax reaction functions of national governments competing with other national governments. After presenting a simple theoretical model, we estimate reaction functions for European countries for a pure Nash model and for a model in which the U.S. can act as a Stackelberg leader while the European countries compete with each other in a Nash way. We initially find a positive Nash reaction function for European countries with respect to capital taxes, but no reaction with respect to labor taxes. Further investigation of the capital tax response results in our main finding, that the European countries behave as if the U.S. is a Stackelberg leader in setting corporate taxes after the U.S. 1986 Tax Reform Act but not before. We also test whether Germany or the United Kingdom played a leadership role and find that they did not. These regression results are reinforced by our Granger causality tests, and are somewhat stronger when we exclude certain tax havens. Over time, European countries seem to have become more intensely competitive with the U.S. in corporate taxes, but less intensely competitive among themselves.