Constrained Tax Competition – Empirical Effects of the Minimum Tax Rate on the Tax Rate Distribution

The paper explores the effect of a minimum tax rate on the tax policy of jurisdictions competing for investment and business location. The testing ground is the universe of local municipalities in the German federation which enjoy the autonomy to set the tax-rate of the local business tax. After experiencing problems with profit-shifting between jurisdictions, in 2004 a federal reform forced municipalities to charge a minimum tax rate on local business profits. As a consequence, low-tax municipalities, i.e. municipalities with tax rates below the minimum, had to adjust their tax policy. In the light of the theoretical literature on minimum tax rates in tax competition, we explore whether the reform has altered the tax-rate distribution beyond the effect on low-tax jurisdictions. More specifically, we test whether municipalities with tax rates above the minimum rate have reviewed their tax policy and decided to set higher tax rates. The empirical results point to significant effects in this regard. We show that the distribution has become more compressed in the bottom part after the reform. Moreover, our results provide quasi-experimental evidence on tax-competition effects in the sense that jurisdictions competing with low-tax jurisdictions have responded with setting higher tax-rates.