The Estimation of Reaction Functions under Tax Competition

Empirical literature on tax competition has often used panel models, where each country’s tax rate responds to a weighted average of other countries’ tax rates. Since weights are exogenous, all countries’ reaction functions are either positive or negative. However, the theoretical literature does not impose exogenous weights. Hence, we propose an alternative approach based on a VAR model with endogenous weights. A Monte Carlo exercise suggests that this latter approach performs better than the former one. Finally, we stress the empirical relevance of the modelling choice showing in a four-country example that the signs of reaction functions estimated with VAR are heterogeneous.