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International Tax and Public Finance

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13-01-2017

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

Author: Willem Sas

Published in: International Tax and Public Finance | Issue 5/2017

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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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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.

Wilson (1986) and Zodrow and Mieszkowski (1986) develop the seminal theoretical models. For a survey of the empirical literature on horizontal interactions, see Brueckner (2003).

McLure (1967), Krelove (1992) or De Borger et al. (2007), for example, consider tax exporting, leading to inefficient overprovision. Keen and Marchand (1997) and Hindriks et al. (2008) discuss the over- or under-provision of productive public inputs, alongside public consumption.

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.

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.

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.

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).

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.

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.

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

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.

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.

This is a common form of notation in the literature focusing on similar issues of decentralised taxation, see, for example, Keen and Kotsogiannis (2002, 2004), Lucas (2004), Brülhart and Jametti (2006), Aronsson and Blomquist (2008) or Kotsogiannis (2010).

A prime denotes the derivative of a function of one variable.

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).

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.

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.

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.

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

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.

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.

See Appendix 1 for the derivations.

This approach is used in, amongst others, Dahlby (1996, 2008), Dahlby and Wilson (2003), Boadway and Keen (1996), Boadway and Tremblay (2006) or Kotsogiannis and Martinez (2008).

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

A proof is given in Appendix 3.

Note that the federal tax rate T comes in through the consolidated tax rate \(\tau \) defining \(w(\tau )\).

Note as well how, in symmetric equilibrium, the federal budget constraint (12) reduces to \(G^{F}=TL_{\mathrm{D}}(w(\tau ))w(\tau )\), using the market-clearing condition (4).

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.

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.

See expressions (41) and (42) in Appendix 4 for the derivations.

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.

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.

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

This point is formally derived in (43) of Appendix 4. Buettner (2006), Smart (2007), Egger et al. (2010) and Ferede (2016) find evidence for such a positive incentive effect studying the tax policies of German municipalities and Canadian provinces.

A proof is given in Appendix 4.

A proof is given in Appendix 6.

A proof is given in Appendix 10.

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

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.

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

Tax base elasticities may indeed vary across countries, also depending on the models used for estimation. See Keane and Rogerson (2012) for an empirical overview of labour supply elasticities, for example, and Lichter et al. (2015) for labour demand elasticities.

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Title: Can fiscal equalisation mitigate tax competition? Ad valorem and residence-based taxation in a federation
Author: Willem Sas
Publication date: 13-01-2017
Publisher: Springer US
Published in: International Tax and Public Finance / Issue 5/2017
Print ISSN: 0927-5940
Electronic ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-016-9435-y

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