Chapter 11: Tax competition in a federal setting
In the standard models of tax competition, as developed by Zodrow and Mieszkowski (1986) and Wilson (1986), regions compete for mobile capital by reducing their tax rates, resulting in inefficiently low tax rates and public good levels. The inefficiencies are caused by the ‘horizontal tax externalities’ associated with tax-induced capital flows. Later literature models competition among a federal government and lower-level governments over a common tax base. In a closed economy, for example, where savings equals investment, an increase in a lower-level government’s taxation of capital leads to lower saving for the economy as a whole, leaving the federal government with a smaller tax base and therefore less tax revenue. This ‘vertical tax externality’ harms all regions by reducing federally-provided public good supplies. By itself, this negative externality implies that regions set their tax rates inefficiently high. More recent literature has sought to identify conditions that determine which of the two externalities dominates. Keen and Kotsogiannis (2002) provides such conditions, and Brülhart and Jametti (2006) use data from Swiss municipalities to find that vertical externalities dominate, thereby demonstrating their empirical importance. In the current chapter, I discuss tax competition in a federal system, emphasizing the role that the federal government can play in correcting the inefficiencies from horizontal and vertical externalities. The use of intergovernmental grants is highlighted, and special attention is devoted to fiscal equalization policies.
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