Effect of agency costs on the optimal matching grant rate in a model of tax competition with benefit spillovers

Abstract Agency problems arise in any environment involving a principal–agent relationship. This study examines the effect of horizontal fiscal externalities on the optimal matching grant rate in a model where agency costs are inevitable. Because this study takes agency costs into account, the main results should differ from the standard conclusions of the tax competition literature. This study finds that the degree of agency costs and benefit spillovers determine the relationship between tax competition and the optimal matching grant rate. If agency costs are relatively small, and benefit spillover is zero, the optimal matching grant rate should increase with the factors of production demand elasticities with respect to the factor tax rate and vice versa. Tax competition thus may ease the inefficiency arising from agency costs only if the disutility of effort is so large that the benefits from tax competition exceed the costs when benefit spillover is zero.