List of Figures
Table of Abbreviations
List of Symbols
2 Taxonomy of fiscal externalities
3 Why vertical fiscal externalities tend to cause inefficiently high tax rates
4 Development of an optimal tax policy to fiscal federalism
4.1 How many levels of government should have the right to levy taxes?
4.2 How should the optimal tax policy be designed?
4.3 Which level of government should excise taxes?
5 Concluding Remarks
A The DWL or Harberger’s Triangles
List of Figures
1 Taxonomy of fiscal externalities
2 Vertical tax externality with tax base overlap
3 Solving the common pool problem through a contribution mechanism
4 Ramsey inverse elasticity rule and comparison of homogeneous and heterogeneous tax policies
5 Dead weight loss or excess burden
Table of Abbreviations
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An implemented tax system causes distortions1 which leads to a minor overall wel- fare level compared to a system without taxes. This deviation in social welfare is often denoted by excess burden or dead weight loss (DWL) of taxation. So the tra- ditional optimal taxation approach comprises the implementation of a tax system which minimizes the excess burden and hence the distortions caused by the levied taxes. Therefore, the policy maker has to anticipate possible behavioral adjustments of the market participants when choosing its optimal tax policy. Assuming the pol- icy maker will do so all effects (i.e. distortions) caused by the tax system will be internalized which means that no fiscal externalities would arise from implement- ing the (optimal) tax system. However, the traditional optimal taxation approach abstracts from any intergovernmental relations as the existence of only one govern- ment and accordingly only one level with fiscal jurisdiction is assumed. The question here is whether and to what extent federal structures (i.e. multileveled government structures) affect the optimal tax policy decision.
The first attempt to take into account the characteristics of a federal system related to optimal tax policy goes back to Gordon (1983) who applied the method- ology of the traditional optimal taxation approach to fiscal federalism. Therein each unit of government (i.e. the federal and usually several state governments) decides independently how much of public goods to provide and in particular which tax policy to use in funding the provided public goods. Hence, we now consider a de- centralized form of decision-making in which each unit of government chooses the optimal tax policy in the best interest of its own residents. As a consequence of this solely intrajurisdictional externalities are internalized analogous to the traditional optimization approach. Though, it isn’t obvious whether this solution is also opti- mal in the sense of an inter jurisdictional point of view. Sobel (1997), Wrede (1999) and also Keen/Kotsogiannis (2002) stated that a common pool problem emerges given that subordinated governments (i.e. state governments) are allowed to levy taxes as well as the federal government. This means that taxation at multiple lev- els lead to a shared tax base which is the fiscal analogue to the common property resource. Due to this overlap in tax bases any separately considered optimal tax policy at a certain level may affect the optimality character of the chosen tax policy of another level. Such spillover effects or rather such interjurisdictional fiscal exter- nalities can arise albeit each level of government choses an optimal tax policy in an intrajurisdictional context. In order to achieve an overall optimal tax policy within a federal system both the intra- and intergovernmental effects due to taxation have to be taken into account. Given that this overall decision is closely connected to the strategic interaction between each level of government the separate policy decisions at any level requires a certain degree of coordination to also internalize the possible effects which can occur between jurisdictions. In the absence of a coordinated decision fiscal externalities lead to inefficiently high tax rates compared to the social optimum. This raises the question how an optimal federal tax system should be designed to minimize the costs of decentralized decision-making?
Gordon’s contribution can be seen as the inception of a research strand whose vast related literature mainly deals with the issue of identifying the sources of fiscal externalities. Thus, the 2nd section includes a brief taxonomy of fiscal externalities and their different forms. Furthermore, the section aims to clarify why we focus upon vertical fiscal externalities. The graphical analysis of the 3rd section illustrates how the upcoming common pool problem leads to inefficiently high tax rates and, thus, distorts the tax policy decisions in a federal system. The 4th section then tries to develop an appropriate reaction of each level of government to ensure the optimality character of the implemented tax policy to fiscal federalism. Section 5 concludes.
2 Taxonomy of fiscal externalities
The exploration of an optimal federal tax policy aims at identifying fiscal externalities responsible for a deviation of the implemented tax system from the optimal tax system. To get the idea of fiscal externalities and in addition to explain why we focus upon vertical externalities a brief taxonomy seems to be expedient.
In contrast to the ordinary definition of externalities as market inefficiencies caused by environmental influences through consumption or production (e.g. pol- lution) fiscal externalities are due to the behaviour of fiscal decision units (e.g. the federal/central government or state/local governments). Fiscal externalities arise because the units within the federal system don’t incorporate the spillover effects affecting other fiscal decision units when choosing their tax policy. If they would anticipate (i.e. internalize) the impact on other tax decisions, fiscal externalities would not arise. In this context should be mentioned that Keen (1995) has pointed out that fiscal externalities within federal systems arise not only at the same level of government (i.e. horizontal fiscal externalities) but also between governments at different levels (i.e. vertical fiscal externalities). The intuition behind the distinc- tion is simply that horizontal fiscal externalities are positive (beneficial) in the sense of too low tax rates (due to tax competition) and vertical fiscal externalities are negative (harmful) in the sense of excessively high tax rates if the federal and the state government share a common tax base.
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Figure 1: Taxonomy of fiscal externalities
(Source: Modified from Köthenbürger (2000): S. 51.)
As illustrated in figure 1 and according to Dahlby (1996) fiscal externalities can take two basic forms. They differ in the way they affect taxpayers in other jurisdictions. Direct fiscal externalities occur when a change in the (e.g. local) government’s fiscal policy has an effect on households of other jurisdictions (i.e. on non-residents) by directly changing their consumer or producer prices or their public good provisions. This change in tax policy also affect the residents but as mentioned in the introduction these effects are already internalized by the local government when it selects its adjusted tax policy. Direct fiscal externalities are always of the horizontal form. An appropriate example of such an externality is tax exporting. This externality refers to a situation where a part of a (local) jurisdiction’s tax revenue is paid by non-residents. This kind of distortion occurs when taxes are levied on goods which are exported to other jurisdictions and the appropriate tax revenues are only beneficial to the jurisdiction of origin. Therefore, the public goods provided by the jurisdiction of origin aren’t entirely funded by its residents. In contrast, the fiscal externality is of the indirect form if an adjusted tax policy of a government does not directly affect the taxpayers of other jurisdictions but rather indirectly by altering the tax revenues (i.e. the fiscal policy) of other governments. The indirect form may be either horizontal or vertical, i.e. between the federal and state government. The latter can only occur in federal structures while the existence of the former is not restricted to federalism. Thus, with the topic in mind, we focus upon the vertical form of fiscal externalities by reason of this feature. Indirect horizontal fiscal externalities arise typically if tax bases are mobile between jurisdictions. For instance, if there are significant deviations in a specific tax rate between jurisdictions (e.g. sales tax) consumers have an incentive to purchase the taxed commodities in the one which offers the lower tax rate and, thus, the lower consumer price. Such behavior is referred to as cross-border shopping (i.e. the mobility of consumers) and leads to downward pressure on tax rates. Therefore, horizontal fiscal externalities of the indirect form are due to tax competition between governments at the same level2. A possible result can be an inadequate provision of public goods as a downward pressure on tax rates leads to a downward pressure on tax revenues as well. In the absence of any form of factor or commodity mobility jurisdictions act in isolation and, therefore, horizontal fiscal externalities of the indirect form cannot arise. In contrast, vertical fiscal externalities distort fiscal policies of fiscal decision units at other levels of governments. They can be categorized with respect to their direction and source. Because of the involvement of multiple levels there can be two possible directions of the externality. On the one hand a vertical spillover can affect the tax policy of the federal government due to a change in the tax policy of the state government which is referred to as bottom-up vertical fiscal externality. On the other hand the opposite case is also possible and is called top-down vertical fiscal externality. The resulting concurrent taxation by federal and state governments leads to a dependency of the appropriate tax policy depending on the direction of the vertical fiscal externality3 and it can have different sources. In the following sections we consider the case of a perfect tax base overlap although it is only one of the potential sources. Thus, the considered spillovers are due to the fact that governments at more than one level impose taxes on (exactly) the same tax base. This kind of source requires tax-setting powers at both levels. Other possibilities even without a perfect overlap are tax deductibility and tax credit, for example. These are cases where the source of the concurrent taxation is given by the reduction of the tax liability towards one level of government by the amount of already paid taxes to other levels of government. For further details on the sources of vertical fiscal externalities see also Keen (1998) and Dahlby/Mintz/Wilson (2000).
1 Here distortions means the change of the behavior of market participants in order to avoid as much of the taxation as possible, e.g. substitution of goods.
2 Such externalities can occur in the same manner between federal governments of two independent states since the same level of governments is considered.
3 This means that in the case of a bottom-up vertical fiscal externality the federal tax policy is dependent on the policy of the states and vice versa.