Edited by Ehtisham Ahmad and Giorgio Brosio
Chapter 13: Tax Competition in a Federal Setting
John D. Wilson Introduction Early models of tax competition, developed by Wilson (1986) and Zodrow and Mieszkowski (1986), were based on Oates’s (1972, p. 143) insight that, ‘In an attempt to keep taxes low to attract business investment, local officials may hold spending below those levels for which marginal benefits equal marginal cost’. The basic source of the inefficiency in these models has been called a ‘horizontal tax externality’: a rise in one region’s tax rate causes mobile capital to relocate to other regions, benefiting them because their tax bases contain this capital. This view of tax competition is not without controversy. In particular, there is now a literature on welfare-improving tax competition, much of it based on the notion that this competition leads governments to behave more efficiently than they would in its absence. See Wilson (1999) for a recent review of the various approaches to modeling tax competition. One relatively recent development has been the construction of tax competition models that contain an important role for a central government. This role introduces a new externality, known as a ‘vertical tax externality’. If the central government and lower-level governments share the same tax base, then an increase in the taxation of this base by one level of government may lower the size of this base for the other level of government. In other words, higher tax rates now create negative externalities, which tend to lead to excessive taxation. We can therefore no longer say that local taxes and expenditures...
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