With the worldwide trend toward free trade, countries have agreed to open their domestic markets and allowed free entry of foreign firms with each other. However, even under such an agreement, they have incentives to strategically arrange the domestic policy and promote their own welfare. In particular, when a country opens its market, one important issue is a price change in the market caused by rapid foreign penetration and a resulting possible decline in domestic production. In this situation, one country’s policy affects trading partners’ market prices. However, strategic interdependence that is caused by the mutual endogenous entry is still an under-researched topic.

This paper theoretically analyzes the subsidy/tax on domestic production as a domestic policy and investigates a new aspect of tax competition between two countries under strategic interdependence through the mutual endogenous entry of foreign firms. Furthermore, as the options to enter the other country’s market, we consider both exports and foreign direct investment (FDI), and derive implications concerning the presence of FDI.

If we focus only on export as the entry method, the production tax causes the trade off between the effects on the profits of domestic firms in the home market and on the tax revenue obtained from the export to the foreign market. Consequently, the equilibrium tax rate is always negative in a symmetric interior case. However, if we take FDI into account, two additional effects appears on the tax revenue from the foreign FDI firms in the home market and on the profits of home FDI firms operating in the foreign market. Both effects increase the production tax rate. Accordingly, the equilibrium tax rate can be positive. We also show that, in terms of world welfare, the equilibrium tax rate is excessively low when it is a subsidy and excessively high when it is a tax. These results imply that the country’s incentive for taxation on domestic production crucially depends on the presence of FDI. Under mutual entry, we have a market force in that FDI increases the domestic tax rate. This force is more substantial than the conventional intuition that FDI makes the excessive subsidy rate lower and the subsidy competition between the countries milder. The presence of FDI can alter the phase of competition to the tax level, and makes such tax competition excessively severe.