International Tax and Public Finance

, Volume 7, Issue 2, pp 119–139 | Cite as

Fiscal Externalities and Efficient Transfers in a Federation

  • Motohiro Sato


This paper investigates properties of the second best allocation in a fiscal federal system in which both federal tax and intergovernmental grants are involved and the taxation is distortionary. Also, optimal federal grants and tax policies in a decentralized fiscal system are examined. Our major findings are: (i) the second best does not require the equalization of marginal cost of public funds across regions in a conventional form; (ii) matching grants based on either the local tax rates or tax revenues should be introduced to internalize the tax externality; and (iii) once lump-sum and matching grants are optimized, federal tax policy becomes redundant so the optimal fiscal gap is indeterminate.

tax externality equalization of MCPFs matching grants optimal fiscal gap 


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© Kluwer Academic Publishers 2000

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  • Motohiro Sato

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