This paper reconsiders the question of whether tax competition for mobile capital
leads to tax rates on capital that are too low or too high from the combined viewpoint
of the competing regions (or countries in an economic union). In contrast to standard
models of tax competition, both commodity trade and capital mobility is allowed to
occur between the competing regions and the rest of the world. A key result of the
analysis is that whether the capital taxes are too low or high depends on the degree
of external trade protection. When the country's central government is free to set
the tariff, tax competition leads to inefficiently low tax rates. But in the absence
of a tariff, tax rates can be too high. In particular, regions may choose to subsidize
capital in equilibrium as a means of inducing favorable terms-of-trade effects, but
the subsidy (i.e., a negative tax) will then be too low because an increase in a
single region's subsidy benefits other regions by reducing their relative quantities
of subsidized capital. These results are discussed in the context of the European
Union's Single Market, where non-EU firms have responded to the 'Fortress of Europe'
by increasing foreign direct investment.