Competitive Externalities of Tax Cuts

Abstract

We examine how tax cuts that benefit some firms are related to the economic performance of their direct competitors. Consistent with tax cuts decreasing the cost of initiating competitive strategies, we find that a decrease in the tax burden for only a certain group of firms in the U.S. economy has a negative economic effect on the performance of its direct competitors not directly exposed to the same tax cut. This negative externality is stronger when competitors (1) face financial constraints, (2) operate in more competitive markets, (3) have similar products to their lower-taxed rivals, (4) face rivals that retain more of their tax benefits (e.g., due to lower shareholder payouts), and (5) face financially constrained rivals. We also find that shareholders and lenders price the negative externality manifested in these competitors’ economic performance.