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Unemployment and endogenous choice on tax instruments in a tax competition model: unit tax versus ad valorem tax

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This paper examines the endogenous choice of unit and ad valorem taxes in a model of tax competition with unemployment. Governments maximize objective functions that are a weighted sum of regional welfare and revenue. In the tax competition model, a high fixed wage rate generates unemployment and employment externalities. This effect can be either positive or negative because of freely mobile capital among regions. Without unemployment, revenue-maximizing governments choose unit taxes as their tax instrument to avoid revenue losses from intense tax competition under ad valorem taxes. However, with unemployment, positive employment externalities generate additional benefits for using ad valorem taxes to stimulate employment. Therefore, the present study shows that one region chooses an ad valorem tax, whereas the other chooses a unit tax, or that both governments use ad valorem taxes depending on employment externalities.

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Fig. 1

Data availability

The data used for the numerical analysis of this study are available from the corresponding author upon request.


  1. For a general overview of the broad tax competition literature, see Zodrow (2010), Keen and Konrad (2013), and Agrawal et al. (2022).

  2. Morita et al. (2020) focused on imperfect labor markets in the context of subsidy competition.

  3. See Sato (2009) and Lee (2021) for the matching and search frictions model, and Eichner and Upmann (2012) and Exbrayat et al. (2012) for the labor union model.

  4. Several studies have found empirical evidence supporting the effect of taxes on employment (e.g., Feld and Kirchgassner, 2003; Harden and Hoyt, 2003; Bettendorf et al., 2009; Felix, 2009; Feldmann, 2011; Zirgulis and Šarapovas, 2017). Almost all related studies discovered a negative relationship between employment and tax rates, implying positive employment externalities. By contrast, Feldmann (2011) showed empirical evidence that higher corporate taxes might lower the unemployment rate, resulting in a negative employment externality. Section 4 discusses the possibility of negative employment externalities.

  5. Several recent studies have examined the nature of tax competition equilibrium with unemployment assuming a fixed wages (e.g., Gillet and Pauser, 2018; Kikuchi and Tamai, 2019; Tamai and Myles, 2022).

  6. Agrawal and Trandel (2019), which studied the dynamics of policy diffusion, derived the conditions for asymmetric policies.

  7. Focusing on tariff war, Lockwood and Wong (2000) showed that the country switching from a specific tariff to an ad valorem tax has an incentive to lower its tariff.

  8. Previous studies made several assumptions about labor market imperfections. For example, Yellen’s (1984) efficiency wage model is the simplest way to justify our model.

  9. This specified production function is a generalized version of that used in the earlier studies by Wildasin (1991), Brueckner (2004), and Akai et al. (2011). To ensure well-behaved factor demand functions, we impose \({A}_{i}{B}_{i}>{\gamma }_{i}^{2}\) (i.e., \({f}_{KK}^{i}{f}_{LL}^{i}-{\left({f}_{KL}^{i}\right)}^{2}={A}_{i}{B}_{i}-{\gamma }_{i}^{2}>0\)).

  10. We provide a discussion about the government’s objective function in Sect. 4.

  11. bK > σ requires that the employment externality be sufficiently small to ensure positive values of Gi. This condition and Assumption 1 lead to a > σ

  12. See Appendix C. For instance, Eq. (C1) is positive if Assumption 3 holds.

  13. According to Frey and Osborne (2017), approximately 47% of the total US employment is in the high-risk category, meaning that jobs could be automated relatively soon.


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The authors would like to thank Nobuo Akai, Mutsumi Matsumoto, Tadashi Morita, and the participants of 2022 Spring Meeting of Japan Association for Applied Economics and Nagoya International Economics Study Group Workshop at Hokkaido University and Tuesday Workshop at Nagoya City University for their constructive comments. We also thank the editor, David Agrawal, and two anonymous reviewers for their helpful comments and valuable suggestions.


This work was supported by JSPS KAKENHI (Grant Numbers: 20H01492; 22H00841; 22K20174).

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Correspondence to Toshiki Tamai.

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Kikuchi, Y., Tamai, T. Unemployment and endogenous choice on tax instruments in a tax competition model: unit tax versus ad valorem tax. Int Tax Public Finance (2023).

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