Fiscal equalisation schemes under competition
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This paper considers optimal fiscal equalisation in a federation that competes with other federations for business tax base. It formalises the argument that, under certain circumstances, federations have an incentive to foster tax competition among their subunits in order to attract tax base from other federations. We show that optimal fiscal equalisation serves the purpose of redistributing income from rich to poor subunits and of choosing an optimal level of tax competition. The latter is chosen as a trade-off between three goals. First, decentralised tax rate setting has positive fiscal externalities within the federation and, thus, tax rates are inefficiently low. Second, in the presence of hold-up problems in investment, tax rates may be inefficiently high. Then, tax competition serves as a commitment device for low future tax rates and is, thus, welfare enhancing. Third, generous fiscal equalisation within the federation is a commitment to not aggressively compete with subunits outside the federation for tax base; as a consequence, with optimal equalisation, equilibrium tax rates are higher within and outside the federation—and even higher than in the case of centralised (i.e. federal level) tax rate setting.
KeywordsBusiness taxation Fiscal equalisation Tax competition
JEL ClassificationH25 H32 H87
We thank an anonymous referee as well as Monika Köppl-Turyna, Jens Malte Zoubek, Chikara Yamaguchi and participants at workshops and conferences in Dresden, Gent, Perth and Dublin for helpful comments. We are especially indebted to Thiess Büttner whose work on tax competition in the region around Frankfurt has inspired this paper. The usual disclaimer applies.
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