Stability and welfare effects of profit taxes within an evolutionary market interaction model

• DOI: http://doi.org/10.1111/roie.12319
• Author: Noemi Schmitt,Frank Westerhoff,Jan Tuinstra
• Published date: 01 August 2018
• Date: 01 August 2018

SPECIAL ISSUE PAPER

Stability and welfare effects of profit taxes within an

evolutionary market interaction model

Noemi Schmitt

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Jan Tuinstra

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Frank Westerhoff

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University of Bamberg, Germany

2

University of Amsterdam, Amsterdam

School of Economics and CeNDEF, The

Netherlands

Correspondence

Frank Westerhoff, Department of

Economics, University of Bamberg,

96047 Bamberg, Germany.

Email: frank.westerhoff@uni-bamberg.de

Abstract

We develop a partial equilibrium model in which firms can

locate in two separate regions. A firm’s decision where to

locate in a given period depends on the regions’relative

profitability. If firms react strongly to the regions’relative

profitability, their market switching behavior generates

unstable dynamics. If the goal of policy makers is to stabilize

these dynamics they can do so by introducing profit taxes

that reduce the regions’relative profitability. While stability

can already be obtained by imposing profit taxes in one of

the two regions, total welfare is maximized if policy makers

coordinate their tax setting behavior across regions. How-

ever, policy makers only interested in welfare in their own

region may have the incentive to decrease their profit tax

below this level, thereby attracting morefirms and increasing

tax revenues, at the cost of instability in both regions.

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INTRODUCTION

We develop a partial equilibrium model in which firms in each period have the choice to locate in one

of two separate regions, labeled region A and region B, and sell their products in that region. A firm’s

decision in which region to locate in a given period depends on the regions’relative profitability. Since

firms only have a limited understanding of their economic environment, they try to identify the

regions’relative profitability from their own past experience and by observing the past success of other

firms. If firms react only weakly to the regions’relative past profitability, the model’s dynamics is sta-

ble and global welfare is maximized. Welfare-reducing fluctuations are set in motion, though, if firms

react strongly to the regions’relative past profitability. The firms’location then leads to price and

quantity fluctuations that are harmful for consumer surplus and firms’profits. Against this background,

we explore whether policy makers are able to stabilize markets by imposing profit taxes. Moreover, we

analyze the welfare effects of such tax policies in order to investigate whether it is optimal for policy

makers to indeed stabilize markets.

Surprisingly, we find that market stability can already be established if a sufficiently high

profit tax is implemented in one of the two regions. However, global welfare is only ma ximized if

Rev Int Econ. 2018;26:691–708. wileyonlinelibrary.com/journal/roie V

C2017 JohnWiley & Sons Ltd

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DOI: 10.1111/roie.12319

policy makers of region A and region B coordinate their tax setting behavior. The explanation for

this may be summarized as follows. Policy makers are able to stabilize the dynamics in both cases

since profit taxes manage to reduce the regions’relative past profitability and thereby slow down

the firms’market switching behavior. The disadvantage of unilaterally imposed profit taxes is that

they distort the optimal distribution of firms across markets with firms relocating to the region

with lower taxes. The advantage of a bilateral tax policy is that it allows for a reduction in the

regions’relative past profitability in such a way that the optimal distribution of firms remains pre-

served. However, policy makers may have an incentive to deviate from a coordinated tax policy.

Starting from a situation in which globally optimal profit taxes are implemented in both regions,

policy makers in one of the regions may try to improve local welfare by reducing profit taxes in

their region. While this may compromise stability, the low-tax region attracts firms from the high-

tax region that may outweigh the cost it suffers from instability.

Our paper is part of a recent stream of literature that investigates the dynamics of market interac-

tions and policy tools to control them. Dieci and Westerhoff (2009, 2010) develop interacting cobweb

market models and find that such systems tend to be more prone to instability than isolated cobweb

markets. Since their cobweb approach entails a supply–response lag, the properties of their models

depend on a four-dimensional nonlinear map. The dynamics of our model depend on a one-

dimensional nonlinear map that enables us to offer an in-depth stability and welfare analysis. Brock

and Hommes (1997) consider a single cobweb market in which firms switch between stabilizing and

destabilizing expectation rules. One of their seminal insights is that endogenous dynamics may emerge

if firms react strongly to the expectation rules’past performance differentials. Schmitt and Westerhoff

(2015, 2016) show that policy makers have the opportunity to stabilize such dynamics by imposing

profit taxes. Here we show that the basic mechanism at work within these models may carry over to

frameworks with multiple regions.

Tuinstra, Wegener, and Westerhoff (2014) develop a cobweb-type model with two regions to study

the stability and welfare effects of trade barriers. Firms from one of the two regions can offer their

products in both regions, while firms from the other region have a cost disadvantage that forces them

to supply their products only in their own market. As it turns out, free trade may lead to price and

quantity fluctuations and thereby hamper welfare. Moreover, trade barriers, modeled in the form of

import tariffs, may stabilize such dynamics and thus have—contrary to conventional wisdom—positive

welfare effects. A similar result is demonstrated by Commendatore and Kubin (2009): while increasing

labor and product market flexibility may increase employment, a deregulated economy may be subject

to welfare-reducing fluctuations. Schmitt, Tuinstra, and Westerhoff (2017) consider a model in which

firms have the opportunity to enter a competitive market and make an uncertain profit or to obtain a

constant profit from a safe outside option. We extend that model by endogenizing the safe outside

option, that is, we allow firms to switch between two risky markets. While the main goal of Schmitt

et al. (2017) is to show that profit taxes may give rise to unexpected dynamic phenomena such as hys-

teresis effects, our focus is on stability and welfare effects of profit taxes.

Our paper is also related to another stream of literature that models market interactions using a

new economic geography perspective. The models by Agliari, Commenda tore, Foroni, and Kubin

(2011, 2014), Commendatore, Kubin, Petraglia, and Sushko (2014), a nd Commendatore, Kubin,

and Sushko (2015) reveal that market interactions between multiple economic regions ma y lead to

complex endogenous dynamics. These papers furthermore demon strate that policy makers have

tools to stabilize the fluctuations of these markets, such as increasing trade costs. Particularly rele-

vant is Commendatore, Currie, and Kubin (2008). They sho w that a small increase in the differ-

ence in taxes (or subsidies) between regions may lead to radical changes in both the dynamics and

the spatial distribution of manufacturers in the Footloose Entrepreneurs model. The beauty of

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