Taxes and Competition: Evidence from the airline industry

Abstract

This paper examines whether corporate tax cuts alter product-market competition by differentially affecting firms with high versus low tax burdens. Tax cuts increase after-tax cash flows for profitable firms but provide little immediate benefit to loss-making firms. We study the 1986 Tax Reform Act, which reduced the top corporate tax rate by 12 percentage points, and examine route-level price and quantity data from the U.S. airline industry. We find that in response to the Act, profitable airlines reduce ticket prices by 4.2% relative to their loss-making rivals and gain 3.3 percentage points in market share. These effects are concentrated in routes where loss-making competitors are financially constrained and are accompanied by increased entry by profitable airlines and exit by loss-making airlines. The evidence suggests that taxes can affect competitive outcomes, specifically in our paper by enabling high-tax firms to compete more aggressively with low-tax rivals after tax cuts.