Social comparisons in consumption, international capital flows and tax competition

• Author: Juin‐Jen Chang,Yi‐Ling Cheng,Shin‐Kun Peng
• DOI: http://doi.org/10.1111/ijet.12117
• Date: 01 March 2017
• Published date: 01 March 2017

doi: 10.1111/ijet.12117

Social comparisons in consumption, international capital

flows and tax competition

Juin-Jen Chang,∗Yi-Ling Cheng†and Shin-Kun Peng‡

This paper explores the implications of consumption externalities for capital mobility,the distri-

bution of firms and tax competition. In the absence of tax competition, the country with higher

consumption externality attracts more capital/firms. In contrast, under tax competition, because

the country with higher consumption externality will impose a higher tax rate on capital, due

to the strong negative effect of taxation, the country with lower externality attracts more capital.

Besides, as trade openness increases, capital agglomerates in the country with lower consumption

externality. We also show that there may exist an efficiency-enhancing role for tax competition.

Key wor ds consumption externality, footloose capital, trade liberalization, tax competition

JEL classification E21, F12, F15, H87

Accepted 27 May2016

1 Introduction

The desire for social status is one of the most important factors driving human behavior. People

can display their social status to others by conspicuous consumption. Such conspicuous behaviors

increase interpersonal influence, giving rise to negative externalities for others. To shed light on social

comparisons in consumption, economists characterize “keeping up with the Joneses” (KUJ) prefer-

ences, indicating that an individual consumer derives her utility by comparing her own consumption

with a reference level which is typically defined as the economy’s averagele velof consumption. With

the comparison of preferences, not only has the importance of consumption externalities been re-

peatedly emphasized, but their implications have also been widely examined in manycontexts. In the

literature, consumption externalities have provided a possible explanation for the equity premium

puzzle (Abel 1990; Gal´

ı 1994; Campbell and Cochrane 1999), and explorations have been carried

out of the patterns of growth (Carroll et al. 1997, 2000; Alonso-Carrera et al. 2004; Turnovsky and

Monteiro 2007), the properties of the business cycle (Lettau and Uhlig 2000), and the effects of

∗Academia Sinica, Nankang, Taipei, Taiwan.

†TunghaiUniversity, Taichung,Taiwan.

‡Academia Sinica, Nankang, Taipei, Taiwan.Email: speng@econ.sinica.edu.tw

Wethank the editor and an anonymous referee for their constructive comments, which helped us to improve the paper.

Also, we are grateful for valuable comments and suggestions fromWen-Tai Hsu, Tomoya Mori, Ping Wang,and Dao-Zhi

Zeng, as well as participants of the Fifth Asian Seminar in Regional Science, the 2015 annual meeting of the Taiwan

Economic Association, and the CEANA session in the 2016 AEA annual meeting. Financial support from the Ministry of

Science and Technology(MOST 104-2410-H-029-004) is gratefully acknowledged.

International Journal of Economic Theory 13 (2017) 47–71 © IAET 47

International Journal of Economic Theory

Social comparisons in consumption Juin-Jen Chang et al.

optimal tax policies (Ljungqvist and Uhlig 2000; Chang et al. 2012), together with their inefficient

consequences (Dupor and Liu 2003; Alonso-Carrera et al. 2004, 2005).

In spite of their importance, consumption externalities seem to be neglected in the literature on

international trade and economic geography.The aforementioned studies confine their attention to a

closed economy,leaving international tr ade and the spatial distribution of capital/firms unexplored.

Recently,Valente (2009) built a two-country endogenous growth model where the utility of agents in

developing countries is affected by consumption gaps with advanced economies, and documented

that international status-seeking behaviors (or between-country social comparisons) tend to reverse

growth differentials in favor of the developing country.While his model endogenizes trade balances,

the international mobility of capital (spatial location of firms) is still ruled out. Going beyond the

existing studies, this paper attempts to explore how social comparisons in consumption affect not

only international trade, but also the geographical concentration of economic activities and the

optimal tax rate for the internationally mobile capital in the process of economic integration.1To

the best of our knowledge, this is the first work that explores such an important issue not only for

its theoretical insights, but also for its wide-ranging policy implications in a framework of the new

trade theory (NTT).

Ever since Krugman (1980), trade integration and factor mobility have been important features

in determining the distribution of firms as well as welfare in the framework of the NTT and the

new economic geography (NEG). The footloose-capital (FC) model of Martin and Rogers (1995)

is widely applied in the NTT literature to examine various issues related to international capital

mobility, industry location, country size and tax competition (e.g., Kind et al. 2000; Baldwin et al.

2003; Ottaviano and Ypersele 2005; Peralta and Ypersele 2005; Chen and Zeng 2014). Going beyond

the existing literature, this paper providesnew insig ht byincorpor ating agents’status-seeking motives

in consumption externalities into an otherwise standard FC model in an NTT framework, in which

international trade incurs iceberg transport costs, capital is fully mobile between the two countries,

and both countries engage in tax competition in order to attract internationally mobile capital.

Our main findings are summarized as follows. In our analytical study, and in the absence of tax

competition, we show that the equilibrium amount/number of capital/firms in a country increases

with the extent of the consumption externalities in this country, but decreasesw ith that extentin the

rival country. In contrast tothe findings of Martin and Rogers (1995), the equilibrium dist ribution of

capital/firms ambiguously responds to trade integration, and is dependent on the relative magnitude

of consumption externalities (the consumption externality effect) between the two countries.

With regard to the tax competition between the two countries, in order to achieve the social

optimum, our numerical study shows that the government could tax rather than subsidize capital

under a Nash equilibrium. In general, a country is more likely to levy a capital income tax when it has

relatively intensive social comparisons in consumption,or when there exist more trade barr iers (i.e.,

low trade openness). This result stands in sharp contrast to the conventional resultof the “race to the

bottom,”as proposed by Baldwin et al. (2003), Ottaviano and Ypersele (2005), and Peng et al. (2016).

The question of whether internationally mobile capital should be taxed is an important issue and is

comprehensively examinedin the NT T literature. The conventionalwisdom indicates that capital tax

competition leads to a race to the bottom, in the sense that the desire to attract internationally mobile

capital, together with trade integration, results in inefficiently low tax rates on capital incomes (see,

1Our paper differs from Valente (2009) in twosig nificant respects.First, we specify w ithin-country social comparisons,

rather than between-country ones, which allows us to provide new implications for the countries with various degrees of

social comparison with the international trade literature. Second, his study focuses on long-run economic growth, while

our attention is directed toward international tax competitionand the spatial distr ibution of firms.

48 International Journal of Economic Theory 13 (2017) 47–71 © IAET