I like the way you move: tax competition in Portuguese Municipal corporate income tax

Abstract

We study tax competition in municipal corporate income tax using a di erence-indi erences approach based on the fact that municipalities with a left-wing mayor set consistently higher tax rates than those with a right-wing mayor. We use a panel of 278 Portuguese mainland municipalities, between 1998 and 2013. We show that leftrun municipalities with a common border with one or more right-run municipalities (the treatment group) set lower tax rates than the remaining left-run municipalities (the control group). We also show that this lower tax rate does not result from a smaller left-leaning preference of the voters of treated municipalities. We build on this di erence-in-di erences approach to provide an instrumental variables estimation of the municipal tax reaction functions. Our preferred estimate suggests that municipalities react to an average increase of 1 pp of the neighbours' tax rate with an own tax increase of 0.884 pp. We show that the strategic interaction is invariant to the political strength of the incumbent mayor, which we take as evidence that tax, rather than yardstick competition, is driving our results.