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The authors set up a model to characterize the reaction functions of governments competing for mobile capital by simultaneously setting both the business tax rate as well as the level of provision of a productive public input. Using a rich data set of local jurisdictions, they then test the predictions of the model with respect to the nature of strategic interaction among governments. Their findings from efficient estimation of a system of spatially interrelated equations for both policy instruments support the notion that local governments use both the business tax rate and public inputs to compete for capital. In particular, they find that if neighbors cut their tax rates, governments try to restore competitiveness by lowering their own tax and increasing spending on public inputs.
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