Firms with heterogeneous profitability: An argument for pick-the-winner strategies in tax and competition policy?

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Models with firm heterogeneity play an important role in the recent theoretical and empirical international trade literature. They have, however, only rarely been used so far to analyse issues of economic policy, even though the empirical relevance of profitability differences between firms is largely undisputed. Against this background this project aims to analyse the implications of firm heterogeneity for tax and competition policies. One important question addressed in this follow-up proposal is whether models with cost heterogeneity of firms, where more productive firms tend to be exporters or engage in foreign direct investment, offer a rationale for discriminatory tax or economic policies. Such ‘pick-the-winner’ strategies are frequently observed in practice, for example in a lower effective tax burden on multinational vis-à-vis nationally operating firms. Another application is in the credit market, where firm heterogeneity causes external effects in the lending policies of banks, thus offering a potential rationale for corrective tax policies. Finally, some of the hypotheses derived in the theoretical analyses of this project shall also be tested empirically. In addition to answering the respective research question, we also aim to develop tractable models that can be used to analyse further policy issues. New modeling strategies are needed because models with firm heterogeneity are typically complex and therefore difficult to apply to a particular policy context. On the other hand important allocative implications of major policy proposals, such as the introduction of a common consolidated corporate tax base in the EU, or the reduction of tax privileges for multinational firms, cannot be derived from models that assume firms to be homogeneous.