## Abstract

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.

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## Notes

- 1.
We only focus on the regional tier within a multi-tiered country, being the state level. Our findings apply to the municipal level as well however.

- 2.
- 3.
- 4.
See Dahlby (1996), Boadway and Keen (1996), or Keen (1998) for the formal derivations. Esteller-Moré and Solé-Ollé (2001, 2002) and Andersson et al. (2004) provide empirical evidence for this kind of vertical tax responsiveness, studying the co-occupied personal income tax base in the USA (states), Canada (provinces) and Sweden (municipalities). See also Goodspeed (2000) for a cross-country study of 13 OECD countries.

- 5.
Wilson and Janeba (2005) add one more channel by endogenising the

*degree*to which public provision can be decentralised by the federal government. The latter is then shown to serve as a strategic tool to compete with rival countries, as it sets the weight of both vertical and horizontal externalities within the federation. - 6.
In a cross-country study of 13 OECD countries, Goodspeed (2002) also finds evidence of this interaction between vertical and horizontal externalities operating through the shared income tax base.

- 7.
Canada is a second example where most tax bases are shared, aside from the resource and property tax which are reserved for the provinces. For a thorough overview of co-occupied tax bases in federal, but also formally unitary states such as France, Spain, Italy or the UK, we refer to Bizioli and Sacchetto (2011).

- 8.
The argument that unit and ad valorem taxes are equivalent as long as a sufficient number of governments compete, which is often made in the literature on international tax competition, also becomes harder to defend in a federal constellation counting a limited set of jurisdictions.

- 9.
See, for example, Persyn and Torfs (2015) and Van der Haegen et al. (2000) on the Belgian case, both highlighting the prevalence of commuting. The latter also discusses historical reasons such as the dense railway network and linguistic barriers. Such linguistic barriers also arise in Switzerland, where Liebig and Sousa-Poza (2006) do not find evidence for tax-induced migration, whereas commuting across linguistic zones does occur as well.

- 10.
See, for example, chapters 2 and 3 in Boadway and Shah (2007).

- 11.
Aside from internalising both types of tax externalities by decentralising the second-best Samuelson condition, an equalisation mechanism can also rectify the inefficient

*allocation*of migrating workers across jurisdictions. See Albouy (2012) for a theoretical generalisation, and an empirical application to the Canadian case. See Bird and Tarasov (2004) or Boadway and Shah (2007) on the equalisation practices in real world federations, many of which are characterised by co-occupied tax bases such as Canada, Switzerland, Belgium or Spain. - 12.
Esteller-Moré et al. (2016), for example, study the efficiency implications of uniform equalisation rates when lobbying is possible at the local, as well as central level. Ogawa and Wang (2016) investigate how a fiscal equalisation scheme can affect tax cooperation in a repeated game setting, with unit taxes on mobile capital.

- 13.
- 14.
A prime denotes the derivative of a function of one variable.

- 15.
Note that since we have normalised state populations to 1, public provision could just as well be considered as pure state public goods as in Kotsogiannis and Martinez (2008).

- 16.
We have thus implicitly ruled out perfect substitutability between state and federal public provision, to avoid corner solutions driven by the vertical and horizontal interactions we wish to study in our model.

- 17.
We abstract from the fact that state taxes are often deductible, or creditable against federal taxes, since this would distract attention from the behaviour of the private sector which we wish to investigate in our model. See, for example, Dahlby et al. (2000) on the issue of deductibility.

- 18.
Normalised state populations keep us from introducing a commuting cost here. However, since costly commuting would not change our key results, this abstraction comes without much loss of generality.

- 19.
See, for example, Boadway and Shah (2009) for a thorough overview.

- 20.
As a result, and following Boadway and Keen (1996), Sato (2000), Aronsson and Wikström (2003), Boadway and Tremblay (2006) or Kotsogiannis and Martinez (2008), the purpose of our model is not to study the reasons for decentralising fiscal

*responsibilities*to the state level, but rather its consequences in terms of decentralised taxation. From this perspective, unitary superiority provides us with a clear normative angle. - 21.
The Atkinson–Stern rule includes an additional term in the numerator, capturing the effect of changes in public provision on tax revenues. Because utility is additively separable in our setting, this relation does not enter here.

- 22.
See Appendix 1 for the derivations.

- 23.
- 24.
A more formal line of reasoning underpinning this approach is given in Appendix 2, alongside a proof of the proposition.

- 25.
A proof is given in Appendix 3.

- 26.
Note that the federal tax rate

*T*comes in through the consolidated tax rate \(\tau \) defining \(w(\tau )\). - 27.
- 28.
Moreover, it can be easily seen that these results do not follow from the assumptions on utility, but are strictly due to taxation practices. Imposing quasi-linear preferences, as in Keen and Kotsogiannis (2002, 2004) simply sets \(\lambda \) equal to unity in (21), which does not alter our results.

- 29.
Since the fiscal capacity differences are entirely equalised, we have modelled a ‘full equalisation’ scheme here. Partial equalisation, where only a fraction of the fiscal capacity divide is bridged, yields identical—but logically less pronounced—results.

- 30.
- 31.
This assumption makes the model more applicable to federations with a smaller number of states, as the federal government now simply optimises over one strategic variable, being its tax rate

*T*, so that its expenditure levels vary residually. See also Keen (1998) for further discussion. - 32.
The intuition is the following. Because \({\bar{B}}\) is used as the equalisation reference, and because \(\sum _{j}^{n}\frac{\partial {\bar{B}}}{\partial t_{i}}=\frac{\partial \left( \sum _{j}^{n}L_{\mathrm{S}_{j}}w\right) }{\partial t_{i}}\) in symmetric equilibrium, the equalisation grants have no impact on the overall per capita federal revenue through equalisation and will as such not induce vertical externalities.

- 33.
As we will show below, this is no longer necessarily the case when ad valorem taxation is source-based rather than residence-based.

- 34.
- 35.
A proof is given in Appendix 4.

- 36.
A proof is given in Appendix 6.

- 37.
A proof is given in Appendix 10.

- 38.
See Appendix 8 for a formal derivation of the source-based case applied to capital taxation.

- 39.
In fact, and as shown by (30), there is an additional correction by \(\frac{\eta }{\epsilon }\) which first of all explains the minus sign before \(T^*\) in (30). This extra adjustment is needed because, in the source-based setting, the negative vertical externality working through the nationwide, shrinking tax base is defined by supply, not demand. The reason for this being, again, the fact that the market clears at the after-tax net return, which is what influences total supply, and indirectly, demand.

- 40.
We thank a referee for bringing this point to our attention.

- 41.

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## Acknowledgements

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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## Appendices

### Appendix 1: Derivation of Lemma 1

After plugging in the profit effect (8), and in symmetric equilibrium, the optimisation problem set out in Sect. 4 yields the same general expression for the marginal rate of substitution as in the unitary case derived in Sect. 3, so that

Plugging in (7), and since \(\frac{\partial {\bar{w}}}{\partial t}=\left( 1-\tau \right) \frac{\partial w}{\partial t}-w=\frac{w\left( n\varepsilon -(n-1)\eta \right) }{n\left( \eta -\varepsilon \right) }\), we get a different expression here

with the gross wage, and labour supply and demand dropping out because of symmetry, and keeping in mind that \(\tau =t+T\). Reworking yields

so that, finally, we obtain

which returns as expression (15) in Lemma 1.

### Appendix 2: Proof of Proposition 1

Consider the unitary optimisation outcome derived in Sect. 3, where the unitary MCPF is derived maximising (9) subject to (10), which boils down to setting \(\frac{\partial W(\tau ,G,G^F)}{\partial \tau }=0\) in symmetric equilibrium, with \(\varGamma _{G}=\varGamma _{G}^F\) following from the first-order conditions on public provision. If, evaluated at the Nash equilibrium where \(\tau =(t^{*}+T^{*})\), we have that \(\frac{\partial W(\tau ,G,G^F)}{\partial \tau }|_{\tau =t^{*}+T^{*}}\lessgtr 0\), state taxation diverges from the second-best optimum, requiring up- or down-wards adjustment moving to second-best efficiency. This latter inequality can then be rewritten as

so that the condition for inefficiency in (36) boils down to the exact same trade-off described in the main text, and the second-best optimum is only attained when \(\mathrm{MCPF}(\tau ^*)=\mathrm{MCPF}_{i}(t^{*},T^{*})\). As soon as the LHS of (36) outweighs the RHS, positive externalities result in undertaxation. Looking at the denominators in (36), and using (35), this is the case when

Reworking then yields

which, after some more manipulation can be written as

or, arriving at expression (16) of Proposition 1,

\(\square \)

### Appendix 3: Proof of Corollary 1

Keeping in mind that \(\varepsilon <0\) and \(\eta >0\), the denominators and the numerators on both sides of (16) will always be negative. A higher equilibrium labour supply elasticity \(\eta \) then brings the denominator on the LHS down in absolute value, and this through \(\left( n-1\right) \tau \eta \) , thus pushing up the bias. Turning to the numerators, we see that \(\eta \) brings about the same effect, but via \(t{}^{*}(n-1)\eta \). The equilibrium labour demand elasticity \(\varepsilon \) on the other hand pulls the perceived MCPF down through \(T^{*}(1+n\varepsilon )\). Lastly, as the state tax rate \(t^{*}\) accounts for a smaller share of the total tax rate \(\tau \), this latter effect comes out reinforced. All four points combined give us Corollary 1. \(\square \)

### Appendix 4: Proof of Proposition 2

Using the federal budget constraint (12) evaluated in symmetric equilibrium, and under the assumption that state governments can see through the part of the federal budget constraint which concerns their own state, (17) can be written as

As explained in the main text, state public provision is augmented with the equalisation grant in (41), so that \(G=twL_{\mathrm{S}}(w(1-\tau ))+\omega (\tau )\), whilst the sum total of equalisation grants comes in as additional federal expenditures. Totally differentiating (41) with respect to *t*, we can then write up the equivalent of (18) here as follows

which reduces to (23) in the main text, and where we prove in Appendix 5 that \(\sum _{j}^{n}\frac{\partial \omega _{j}}{\partial t}=0\), so that equalisation does not give rise to vertical externalities. In order to filter out the externalities subsequently, we subtract (42) from (20) as in Sect. 4, to obtain

where, contrary to (21), the vertical externality expressed by \(\varGamma _{G^{F}}\left( wL_{\mathrm{D}}^{'}+L_{\mathrm{D}}\right) \) is now of degree \(\left( 1-\frac{1}{n}\right) \) as well, and the incentive effect of equalisation \(\frac{\partial \omega }{\partial t}\) drives states to increase their tax rates as it pulls (43) down. Setting (43) to zero and solving for \(\frac{\partial \omega }{\partial t}\), we then obtain the prerequisite for any equalisation grant to internalise all externalities as

With (44) plugged into (42), the latter will indeed be equal to (20) set to zero, imposing second-best efficiency. \(\square \)

### Appendix 5: Proof of federal equalisation neutrality

Starting from the sum total of equalisation grants included in (41) above, we get

Differentiating (45) with respect to \(t_{i}\) yields

which, evaluated in symmetric equilibrium where \({\bar{B}}=B_{i}\) and \({\bar{t}}=\frac{\sum _{i}^{n}t_{i}L_{\mathrm{S}_{i}}w}{\sum _{i}^{n}L_{\mathrm{S}_{i}}w}=t\) for all *i*, reduces to

Focusing first on the first term between brackets on the right-hand side of (47), we have that

so that

or

which also defines (25) in the main text. Similarly, examining the second term between brackets on the right-hand side of (47), we have that

so that

Plugging both (50) and (52) into (47), then yields

\(\square \)

Driving this result is the effect of a tax hike by a single state *i* on the overall federal per capita tax base \(\sum _{j}^{n}\frac{\partial {\bar{B}}}{\partial t_{i}}\), which is identical to the change in all state tax bases \(\sum _{j}^{n}\frac{\partial \left( L_{\mathrm{S}_{j}}w\right) }{\partial t_{i}}\) due to the same tax increase in \(t_{i}\). More specifically, because \({\bar{B}}\) is used as the equalisation reference, and because \(\sum _{j}^{n}\frac{\partial {\bar{B}}}{\partial t_{i}}=\sum _{j}^{n}\frac{\partial \left( L_{\mathrm{S}_{j}}w\right) }{\partial t_{i}}\) in symmetric equilibrium, equalisation grants will have no impact on the overall per capita federal revenue used for equalisation and will not induce vertical externalities as a result.

### Appendix 6: Proof of Corollary 2

Plugging in (6), we can write (26) as

where we have also used the federal budget constraint (12) evaluated in symmetric equilibrium, and the fact that

or,

Assuming now that \(\lambda =\varGamma _{G}=\varGamma _{G^{F}}\), and using (25), then allows us to write (54) as

Since \(nG^{F}=TnL_{\mathrm{S}}w\) and \(G=tL_{\mathrm{S}}w\), (57) becomes

which, after some further manipulation gives us

so that

where the factor *z* can be written as

Hence, using (6), we arrive at

or,

which, as noted above, could only be derived under the condition that \(\lambda =\varGamma _{G}=\varGamma _{G^{F}}\). But this condition never holds since taxation is distortionary, so that even in the unitary optimum where \(\varGamma _{G^F}=\varGamma _{G}\), because \(\frac{\varGamma _{G^F}}{\lambda }=\frac{\varGamma _{G}}{\lambda }\), we still have that \(\varGamma _{G^{(F)}}>\lambda \) since \(\frac{\varGamma _{G^F}}{\lambda }=\frac{\varGamma _{G}}{\lambda }=\frac{1}{\left( 1-\frac{\tau \eta \varepsilon }{(1-\tau )\varepsilon -\eta }\right) } >1\).\(\square \)

### Appendix 7: Residence-based tax on mobile capital

Let \(S_{i}(\rho _{i})\) be the savings of citizens in state *i*, invested at a net interest rate of \(\rho _{i}=(1-\tau _{i})r\) with \(\tau _{i}\) the residence-based tax on savings in state *i*, and \(K_{i}(r)\) the capital applied to production in state *i* at the market-clearing interest rate \(r(\varvec{\tau })\). The latter follows from the equilibrium on the capital market

which, because of residence-based taxation, implies that investors relocate their savings until capital earns the same gross returns across states. Utility in state *i* is then given by

where, as in Keen and Kotsogiannis (2002, 2004), \(C_{i1}\) defines consumption in period 1 as the difference between endowed income *e* and savings

and \(C_{i2}\) is equal to accrued savings in period 2 plus rents \(\pi _{i}\) from state production

with rents given by

and \(u_i(.)\) and *g*(.) having the same properties as in the main text. As in Brülhart and Jametti (2006), first period consumption could also be defined as foreign investment, at a normalised net interest rate of zero, and period 2 consumption as domestic investment. Consumers then maximise utility given (66), (67) and (68), so that savings \(S(\rho _{i})\) are implicitly defined by \(\frac{\partial u_{i}}{\partial C_{i2}}(.)(1+\rho )-\frac{\partial u_{i}}{\partial C_{i1}}=0\), and assumed increasing in \(\rho _i\). Using the federal budget constraint (12) evaluated in symmetric equilibrium, indirect utility is then given by

which is the exact equivalent of (41), but here in the context of capital taxation. Totally differentiating (69) with respect to *t* then yields

with \(\frac{\partial W}{\partial t}=0\) characterising the equilibrium tax rate \(t^{*}\). Differentiating (69) with respect to a common tax rate \(t=t_{c}\) as before, we get

In order to filter out the externalities, we subtract (70) set to zero from (71) as in Sect. 4 with \(\frac{\partial W}{\partial t_{c}}|_{t_{c}=t\text {*}}\), to obtain

which, since \(r'>0\), gives rise to exactly the same externalities as in Corollary 2. What this implies is that we can always switch from a capital to a labour income setting, without loss of generality regarding the deduced externalities.

### Appendix 8: Source-based tax on mobile capital

Let \(K_{i}(r_{i})\) now be the capital applied to production in state *i* at a gross rate of return \(r_{i}\), and \(S_{i}(\rho )\) the savings of citizens in state *i* invested at a market-clearing net interest rate of \(\rho =(1-\tau _{i})r_{i}\), with \(\tau _{i}\) the source-based tax on capital applied in state *i*. The net return \(\rho (\varvec{\tau })\) to investment follows from the equilibrium on the capital market defined by

which, because of source-based taxation, implies that investors relocate their savings until capital earns the same net returns across states. Taking the total differential with respect to \(\tau _{i}\) of (73) yields

Rewriting net wages in terms of the gross wage and solving further then gives us

so that, factoring out and bringing over, we arrive at

which, given symmetry and since \(\frac{\partial \tau _{i}}{\partial t_{i}}=1\), becomes

with \(\eta =S'\frac{\rho }{S}>0\) the savings elasticity and \(\varepsilon =K'\frac{r}{K}<0\) the capital demand elasticity in state *i* in the symmetric equilibrium. Totally differentiating (73) with respect to the common tax rate *T* subsequently, and again given symmetry, we find that

which also defines

and, \(\forall j \ne i\),

Utility in state *i* is then given by

of which the arguments are the same as in Appendix 7. Consumers maximise utility given (66), (67) and (68), so that savings \(S(\rho )\) are implicitly defined by \(\frac{\partial u_{i}}{\partial C_{i2}}(.)(1+\rho )-\frac{\partial u_{i}}{\partial C_{i1}}=0\). Using the federal budget constraint (12) evaluated in symmetric equilibrium, indirect utility is now given by

which is the source-based counterpart of (69). Now, since \(\frac{\partial r_i}{\partial t_i}\ne \frac{\partial r_j}{\partial t_i}\), and using (79) and (80) as a result, we know that

or,

so that, totally differentiating (82) with respect to *t*, we obtain

with \(\frac{\partial W}{\partial t}=0\) characterising the equilibrium tax rate \(t^{*}\). Differentiating (82) with respect to a common tax rate \(t=t_{c}\) subsequently, we get

In order to filter out the externalities, we subtract (85) set to zero from (86) as in Sect. 4, with \(\frac{\partial W}{\partial t_{c}}|_{t_{c}=t\text {*}}\), to obtain

or, using (77),

We thus find that in the case of source-based taxation, both the vertical and horizontal externalities still have an ambiguous sign, whilst the horizontal externality is composed differently. The profit effects will now have a positive effect on non-resident welfare, as \(\frac{\partial \rho }{\partial t}<0\) pulls down the rate of return \(r_{j\ne i}\) to be paid by firms in other states. Inversely, and again because \(\frac{\partial \rho }{\partial t}<0\), the effect on tax revenues collected in other states will now also have a negative side.

### Appendix 9: Equalisation and source-based taxation: Corollary 4

To compare equalisation in the source-based scenario derived in Appendix 8 with the residence-based setting, we consider the same equalisation mechanism (22) we had before

where now \({\bar{t}}=\frac{\sum _{i}^{n}t_{i}K_{i}r_{i}}{\sum _{i}^{n}K_{i}r_{i}}\) is the average state government tax rate. \(B_{i}\) is the fiscal capacity of state *i*, captured by its tax base \(K_{i}r_{i}\), whilst \({\bar{B}}=\frac{\sum _{i}^{n}K_{i}r_{i}}{n}\) is the benchmark fiscal capacity, being the average federation-wide tax base. Deriving the equalisation grant w.r.t. \(t_{i}\) gives us

Similar to the symmetric residence-based setup, we again have that a tax hike in state *i* only influences the equalisation grant through a change in the actual fiscal capacities, as \({\bar{B}}=B_{i}\) in symmetric equilibrium, so that

or,

from which, using (79) and (80) and reworking, we obtain

Solving further then yields

and finally, since \(\rho =(1-\tau )r\),

or, in terms of a general production factor *P*, with \(P_D\) the supply of the taxed production factor per state, and *p* the market price,

which returns as (31) in Corollary 4. \(\square \)

### Appendix 10: Proof of Proposition 3

To derive the conditions for an efficiency-enhancing equalisation grant, we introduce the marginal equalisation effects to (88) following the same approach set out in Appendix 4, so that now

Setting (97) to zero and solving for \(\frac{\partial {\hat{\omega }}_{i}}{\partial t_{i}}\) yields

which, plugged in, reduces (85) to (86) set to zero, ensuring second-best efficiency. Using (77) and rewriting, we then get

from which, introducing the marginal equalisation effect of the conventional grant given by (95), we obtain

Rewriting (100) in terms of a production factor *P* with *p* the market-clearing price, and simplifying further, we finally arrive at

as expressed by (30) in Proposition 3. To compare (101) with the residence-based case, we start from expression (26) of Proposition 2 where

Since we know from (4) that \(\sum _{i}^{n}\frac{\partial \left( L_{\mathrm{D}_{i}}w\right) }{\partial t_{i}}=\sum _{i}^{n}\frac{\partial \left( L_{\mathrm{S}_{i}}w\right) }{\partial t_{i}}\), and \(\sum _{i}^{n}\frac{\partial \left( L_{\mathrm{D}}w\right) }{\partial t}=n(L_{\mathrm{D}}\frac{w'}{n}+L'_{D}\frac{w'}{n}w)=L_{\mathrm{D}}w'+L'_{D}w'w\) in symmetric equilibrium, we also have that

where \(\sum _{i}^{n}\frac{\partial \left( L_{\mathrm{S}_{i}}w\right) }{\partial t_{i}}=L_{\mathrm{S}}^{'}\left( (1-\tau )w'-w\right) w+L_{\mathrm{S}}w'\) follows from (56). Applying this latter equivalence to the right-hand side of (102), we obtain

which, using (6), can be rewritten as

or, since \(\frac{\partial \omega _{i}}{\partial t_{i}}=t_{i}\left( \frac{n-1}{n}\right) L_{\mathrm{S}}^{'}w^{2}\), as

which, rewritten in terms of a production factor *P* with market price *p*, yields

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### Cite this article

Sas, W. Can fiscal equalisation mitigate tax competition? Ad valorem and residence-based taxation in a federation.
*Int Tax Public Finance* **24, **817–853 (2017). https://doi.org/10.1007/s10797-016-9435-y

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### Keywords

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

### JEL Classification

- H71
- H77
- H23