Eco-friendly location under fiscal competition

Pollution is an intra-regional transboundary issue that influences government policies in attracting a multinational enterprise (MNE) with advanced production and clean technologies. This study analyzes fiscal competition between two asymmetrically sized countries under a production-based pollution. An indigenous local firm exists in the large country, and both countries design a lump-sum fiscal policy to attract an MNE external to the region. We find that fiscal competition under transboundary pollution shifts the MNE’s equilibrium location from the large country to the small country when inter-regional trade costs are sufficiently low. The small country successfully attracts the MNE with a tax because the counteroffer by the large government has a heavier tax. Moreover, fiscal competition makes the large country more attractive to the MNE when pollution outflows cause significant damages and the MNE has a cleaner technology.