International Tax and Public Finance

, Volume 24, Issue 5, pp 817–853 | Cite as

Can fiscal equalisation mitigate tax competition? Ad valorem and residence-based taxation in a federation

  • Willem Sas


In this paper, we revisit the combined effect of horizontal and vertical tax externalities in a federal context, extending the theoretical framework of Keen and Kotsogiannis (Am Econ Rev 92(1):363–370, 2002) by allowing for ad valorem and residence-based taxation. When taxes are levied ad valorem rather than per-unit firstly, we find the interaction between both types of externalities is more ambiguous than commonly understood. As a result, and contrary to earlier findings, fiscal equalisation mechanisms such as the representative transfer system (RTS) fail to fully internalise the tax externalities. Given these limitations, we derive the conditions under which a standard RTS will either: (1) at least nudge politicians in the right direction; (2) realise no welfare gains at all; (3) considerably overshoot the second-best efficiency mark causing welfare loss. Lastly, we find that when taxation is residence-based rather than source-based, a different kind of competition emerges where tax cuts are aimed at stimulating outward factor flows, rather than attracting inward flows.


Tax competition Ad valorem taxation Vertical and horizontal externalities Fiscal equalisation Residence-based taxation Fiscal federalism 

JEL Classification

H71 H77 H23 



This is a revised version of a chapter of my PhD dissertation. I gratefully thank Thomas Aronsson, Robin Boadway, Thiess Buettner, André Decoster, Susana Peralta, Stef Proost, Albert Solé-Ollé, two anonymous referees and participants at the IIPF Annual Conference in Dublin, the ERSA Annual conference in Lisbon, the Halle Colloquy on Local Public Finance, the ZEW conference on fiscal equalisation in Mannheim, and the 15th Journées Louis-André Gerard-Varet in Aix-en-Provence for very helpful comments and suggestions to this or an earlier version of the paper. The financial support of BELSPO (Contract TA/00/39) and the ‘Steunpunt beleidsrelevant Onderzoek Fiscaliteit en Begroting’ (2011–2015) is also much appreciated. The usual disclaimer applies.


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Copyright information

© Springer Science+Business Media New York 2017

Authors and Affiliations

  1. 1.Department of EconomicsKU LeuvenLeuvenBelgium

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