Fiscal competition for foreign direct investment with knowledge spillovers and trade costs

We develop a model of fiscal competition for foreign direct investment, and show that the decision of multinational firms to locate in the proximity of indigenous firms – which can be thought of as agglomeration – may be the result of the provision of government incentives that aim to capitalise on the potential for knowledge spillovers to indigenous industry. Somewhat different but complementary to existing literature, we also show that fiscal competition may increase the welfare of both winning and losing countries in the auction for the multinational firm when it leads to the relocation of multinationals away from countries that do not have the potential to benefit from knowledge spillovers to countries that do. As trade costs fall and the potential for knowledge spillovers increases, both outcomes become more likely in equilibrium.