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International Tax and Public Finance

Erschienen in:

18.01.2017

Fiscal equalisation schemes under competition

verfasst von: Johannes Becker, Michael Kriebel

Erschienen in: International Tax and Public Finance | Ausgabe 5/2017

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Abstract

This paper considers optimal fiscal equalisation in a federation that competes with other federations for business tax base. It formalises the argument that, under certain circumstances, federations have an incentive to foster tax competition among their subunits in order to attract tax base from other federations. We show that optimal fiscal equalisation serves the purpose of redistributing income from rich to poor subunits and of choosing an optimal level of tax competition. The latter is chosen as a trade-off between three goals. First, decentralised tax rate setting has positive fiscal externalities within the federation and, thus, tax rates are inefficiently low. Second, in the presence of hold-up problems in investment, tax rates may be inefficiently high. Then, tax competition serves as a commitment device for low future tax rates and is, thus, welfare enhancing. Third, generous fiscal equalisation within the federation is a commitment to not aggressively compete with subunits outside the federation for tax base; as a consequence, with optimal equalisation, equilibrium tax rates are higher within and outside the federation—and even higher than in the case of centralised (i.e. federal level) tax rate setting.

Vorheriger Artikel Would less regional income distribution justify the present call for devolution?

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

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As Kehoe (1989) shows, even benevolent governments may expropriate their citizens. The ‘taming the Leviathan’ view is therefore not necessarily incompatible with assuming that governments maximise the representative household’s utility. The system of fiscal equalisation may be seen as part of the fiscal constitution that effectively prevents the subunits’ governments from (benevolently) exploiting their citizens.

See Eaton and Gersovitz (1983, 1984), Janeba (2000), Konrad and Lommerud (2001), Schnitzer (1999, 2002), Thomas and Worrall (1994).

The federal level itself does not levy business taxes. Thus, there are no vertical externalities as in Keen (1998), Keen and Kotsogiannis (2002), Kessing et al. (2009). With vertical externalities, decentralised policy-making in a federation may be a disadvantage in attracting mobile capital.

Agrawal (2016) provides empirical evidence for inter-federation tax competition. See Brueckner (2004) for a survey on fiscal decentralisation.

See also Hayashi and Boadway (2001).

The absorption rate on the state’s income can be economically substantial. For instance, the marginal absorption rate on a German state (Land) varies between 70 and 92% (Baretti et al. 2002). For Canadian provinces (Smart 2007) and Australian states (Dahlby and Warren 2003), the absorption rates are significantly smaller, in other federations (most importantly, the EU) a fiscal equalisation scheme is entirely missing.

For evidence for tax effects on capital investment across subnational entities, see e.g. Becker et al. (2012).

The production functions may include some fixed input factor (e.g. entrepreneurship, land) which makes them effectively have constant returns to scale. We oppress this fixed factor for simplicity of notation.

Liesegang and Runkel (2016) analyse tax competition with fiscal equalisation with profit taxes instead of unit taxes on capital.

These tax rates are also referred to as ‘representative tax rates’, see e.g. Boadway (2004).

Note that this does not necessarily imply a chronological order. An equivalent timing would have the firms in the k-sector invest at stage 2 (like the firms in the \(\kappa \)-sector), but adjust their capital stock after taxes have been revealed.

If firm owners cannot, by assumption, pay more than their full profit, the welfare curve would have a kink due to a fall in tax base affected by a marginal tax increase. Then, the tax base would be \(K_{i}\) for \(t_{i}\le \frac{g\left( \kappa \right) -r\kappa }{\kappa }\) and \(\lambda _{i}k_{i}\) for larger tax rates. Due to the kink, it might be that, in the optimum, the first-order condition for the optimisation problem in (8) is \(\frac{ du(x_{i},g_{i})}{\text {d}t_{i}}>0\). In the following, we abstract from these complexities since they do not yield new insights.

If \(\gamma _{j}=0\), (9) reads \(\left( u_{g}^{i}-u_{x}^{i}\right) K_{i}+u_{g}^{i}t_{i}\lambda _{i}\frac{\text {d}k_{i}}{\text {d}t_{i}}=0\). With \(\frac{\text {d}k_{i} }{\text {d}t_{i}}<0\) and \(\lambda _{i}>0\), it follows \(u_{g}^{i}>u_{x}^{i}\) (since there is no other source of revenue and \(u_{g}^{i}>u_{x}^{i}\) for \(t_{i}=0\)).

Technically speaking, an increase in \(\gamma _{j}\) increases the left-hand side of (9). Note that, under symmetry, \(\gamma _{j}\) does not affect \(u_{g}\) (or \(u_{x}\)) directly as it does not directly affect \(T_{i}\), see Eq. (3).

In fact, in the literature it is often assumed that strategic complementarity holds although this is not necessarily the case for all model parameters (see Appendix for further discussion). As Keen and Konrad (2013) put it in their Handbook article: ‘Intuition might suggest, in particular, that the best response to a reduction in some other country’s tax rate will be for i to reduce its own rate too; meaning that tax rates are strategic complements. But this is not, in general, assured (even in the case of symmetric countries)’. (p. 267) See also Devereux et al. (2008, pp. 1217–19) for a discussion on the assumption of strategic complementarity of tax rates. The evidence supports this assumption. Be it for tax competition between subnational units (Büttner 2001) or between countries (Devereux et al. 2008; Overesch and Rincke 2011), empirical studies typically measure a positive slope of the reaction function, i.e tax rates are strategic complements.

The need for public funds as measured by \(\frac{u_{g}^{i}-u_{x}^{i}}{ u_{g}^{i}}\) depends on the size of public funds and is thus not independent of \(t_{ij}\). However, since \(\frac{u_{g}^{i}-u_{x}^{i}}{u_{g}^{i}}\) can be expected to decrease in the availability of public funds from other sources, the above statement may be rephrased as follows: The optimal tax rate decreases in public funds from other sources.

Relaxing this assumption (i.e. allowing for sector specific tax rates) would decrease the optimal tax rate in (10) on the mobile sector to \(t_{ij}^{*}=\left[ \frac{u_{g}^{i}-u_{x}^{i}}{u_{g}^{i}}\frac{1}{ \left| \eta _{k_{i}}\right| }+\gamma _{j}\frac{n-1}{n}\right] \frac{ mn}{mn-1}\).

For instance, if the flexible sector is triple the size of the inflexible one and elasticities are equal, optimal equalisation is zero if \(m=n=3\).

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Titel: Fiscal equalisation schemes under competition
verfasst von: Johannes Becker
Michael Kriebel
Publikationsdatum: 18.01.2017
Verlag: Springer US
Erschienen in: International Tax and Public Finance / Ausgabe 5/2017
Print ISSN: 0927-5940
Elektronische ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-016-9437-9

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