Do you recall when Amazon’s HQ2 announcement triggered a heated bidding war across U.S. cities and states? In 2019, Virginia’s Senate approved a tax incentive package of up to US$750 million, beating competitors such as Maryland and New Jersey to secure the tech giant’s investment.
What about Intel in Costa Rica? The semiconductor manufacturer decided to open a plant there in the mid-1990s after a competitive site-selection process involving several Asian and Latin American countries. Several factors, including Costa Rica’s tax breaks through a free-trade-zone regime, persuaded Intel to choose the Central American country as the location for its new production site.
Are you familiar with Apple’s landmark dispute with the European Union regarding the tax breaks it received to operate in Ireland? These are just a handful of examples of a phenomenon that recurs worldwide. Anecdotes of government competition over firms are widespread: virtually every continent (and country) has its own example. In such cases, governments unilaterally offer sizable tax incentives to persuade firms to locate or relocate production within their jurisdiction. Economists have coined several terms to describe this phenomenon, including subsidy competition, tax competition, and the race to the bottom. In my job market paper, I study what is arguably one of the most heated cases of tax competition in the world: Brazil’s Fiscal War.
For decades, media outlets, government officials, and intergovernmental organizations have highlighted the severity of tax competition among Brazilian states. Since its implementation in 1965, Brazil’s distinctive VAT system has allowed states to offer sizable tax incentives to attract firms. To estimate the extent of this competition, I compile a novel dataset encompassing tax entitlements forgone at the state-sector level in 2023. Using these data, I estimate that roughly 25 percent of all state tax entitlements were waived through tax incentives in that year, corresponding to a nationwide sticker price of US$44.66 billion. Table 1 illustrates the extent to which (on paper) states waive VAT entitlements through tax incentives. Over time, concerns have mounted that this intense competition has generated significant distortions in the Brazilian economy.
One might conjecture that this tax competition does not generate new economic activity, but instead merely induces firms to shuffle back and forth across state borders. At the same time, states may be forced to compromise their tax collection — and consequently their ability to provide public goods and services — in order to retain economic activity. Moreover, firms might be incentivized to locate in regions where they are unproductive or incur higher transportation costs simply to enjoy tax breaks.
My job market paper sheds light on the tax competition puzzle by addressing three key questions.
Which firms do governments compete over?
I show, both theoretically and empirically, that Brazilian states tax immobile sectors more heavily, while levying lower taxes on mobile sectors of the economy. In particular, manufacturing firms receive substantially more tax breaks than their services counterparts. Despite enjoying the same statutory tax rates, once we account for tax breaks, the median effective VAT rate across Brazilian states is 7 percent in manufacturing, while the median effective VAT rate in services is 13 percent. In fact, in every single Brazilian state, manufacturing firms face lower effective tax rates relative to service firms, as Figure 1 shows.
Intuitively, states face strong incentives to levy lower taxes on manufacturing as — likely due to the tradable nature of its output — firms in manufacturing can easily relocate production to other states in search of better tax incentives. Firms in the service sector, on the other hand, cannot credibly demand greater tax breaks as they cannot relocate as easily in response to higher taxes.
Do all states lose from tax competition?
I estimate which states lose and which win (if at all) from their ability to lure firms through tax breaks. I compare in a general equilibrium spatial framework how average consumption and public goods provision would change if Brazil were to kill tax competition by imposing a single VAT rate nationwide. In short, there is substantial heterogeneity in the effects of tax competition across states. Not all states lose from tax competition; in fact, some Brazilian states are much better off when competing for firms.
Smaller states close to the country’s two biggest markets, São Paulo and Minas Gerais, can attract considerable amounts of economic activity at mild tax rate discounts. Therefore, eliminating tax competition will lead to considerable declines in consumption as these states are no longer appealing to firms. Proportionally, isolated markets stand to gain the most from eliminating tax competition. Intuitively, these states (Maranhão, Piauí, and Pará) have limited ability to attract firms even under tax competition. They also stand to gain substantially if distortions associated with location decisions are eliminated.
On the other hand, with few exceptions, states stand to gain substantially in terms of tax revenues if Brazil were to harmonize tax rates. Without the threat of being undercut, states can enjoy higher tax revenues (and consequently higher public goods provision) under a uniformly higher tax regime.
What is the aggregate cost of tax competition in Brazil?
Finally, I estimate the aggregate cost of tax competition nationwide. Similar to my previous exercise, I simulate counterfactual scenarios with a uniform value-added tax rate applied to the whole country’s consumption and examine the resulting tax revenue. I find that there is a “sweet spot” where uniformization can result in aggregate gains in both consumption and public goods provision. A VAT rate between 10.6 percent and 11.9 percent is estimated to lead to improvements in both consumption and public goods provision. At a tax rate of 10.6 percent, aggregate public goods provision remains unchanged, while nationwide consumption increases by 1.6 percentage points. Conversely, a VAT rate of 11.9 percent leads to no change in aggregate consumption, while increasing public goods provision by as much as 11 percent.
Policy Implications
I derive three policy implications from my job market paper. First, eliminating tax competition provides an enticing opportunity to increase aggregate consumption and improve public goods provision worldwide. While complete tax uniformization is often legally unfeasible across international and intranational governments, I highlight the potential aggregate gains of even imposing limitations on states’ ability to lure firms through tax incentives.
Second, I highlight the heterogeneous spatial impacts of limiting tax competition. Some states in Brazil stand to gain and some to lose in terms of consumption as a result of eliminating tax competition. Coupling compensatory measures with policies to reduce locational tax incentives is key to reducing the negative impacts of eliminating Brazil’s fiscal war. Moreover, compensatory measures can be key to implementing limitations on tax competition, especially when adherence to these policies is voluntary.
Third, I show that tax competition has an important sectoral component. Firms are subject to different relocation incentives depending, among other factors, on their economic sector. Namely, I show evidence to support the claim that firms in manufacturing are disproportionately targeted by governments in the fiscal war. Understanding which other firm features and subsectors demand greater tax breaks in the context of tax competition can help refine measures to remedy its negative aggregate effects.
About the Author
Plinio Dias Bicalho is a Ph.D. candidate at Boston University.
His research at the intersection of international trade, macroeconomics, public finance, political economy, and machine learning. To learn more about his research, visit: https://pliniobicalho.com/
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