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Fiscal Externalities and Efficient Transfers in a Federation

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Abstract

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.

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Authors
  1. Motohiro Sato
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Sato, M. Fiscal Externalities and Efficient Transfers in a Federation. International Tax and Public Finance 7, 119–139 (2000). https://doi.org/10.1023/A:1008709203069

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