An implemented tax system causes distortions which leads to a minor overall welfare 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 traditional 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 policy 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 implementing the (optimal) tax system. However, the traditional optimal taxation approach abstracts from any intergovernmental relations as the existence of only one government 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 methodology
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 decentralized
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 optimal
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 levels
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 ...
Table of Contents
1 Introduction
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
Objectives and Topics
This paper examines the impact of vertical fiscal externalities on tax policy within federal systems, specifically focusing on how the shared tax base between different levels of government leads to inefficiently high tax rates. The central research question explores how an optimal federal tax system should be designed to internalize these externalities and minimize the costs of decentralized decision-making.
- Analysis of vertical fiscal externalities and the common pool problem.
- Application of the Ramsey inverse elasticity rule to federal tax systems.
- Evaluation of optimal tax base allocation among government levels.
- Examination of tax rate efficiency in heterogeneous vs. homogeneous jurisdictions.
Excerpt from the Book
3 Why vertical fiscal externalities tend to cause inefficiently high tax rates
In the case of vertical fiscal externalities multiple levels of government are simultaneously authorized to set taxes on the same tax base. This situation leads to dependencies of tax policies within federal systems of governments. In describing how such externalities affect fiscal behavior of governments, we will use the implications for the marginal cost of public funds (MCPF) or rather for the social marginal cost of public funds (SMCPF). They can be defined as the economic cost to taxpayers of raising an additional monetary unit of tax revenue. Thereby the MCPF are the perceived marginal cost (at a specific level of government) whereas the SMCPF are the true or overall marginal cost of the entire federal system. This means that the latter encompasses all effects of a marginal increase in a tax rate whereas the MCPF maybe does not. Since the MCPF is a fundamental parameter in the tax policy decision calculus and vertical fiscal externalities can cause deviations between MCPF and SMCPF they, therefore, can lead to a bias in fiscal decisions.
Now we consider a situation where the federal and the state government share a tax base and the combined tax rate is the result of a coordinated fiscal decision. Thus, the tax burden of the taxpayers is optimal in the sense that the overall tax revenue is maximized and an appropriate amount of public goods can be provided by both levels of governments. At this point the MCPF and the SMCPF are equal. This is illustrated in figure 2 with the consumer price p0 and the appropriate quantity of x0. Additionally a perfectly elastic supply curve S is assmued. The federal tax rate stays constant at tf and the initial tax rate at the state level denotes as ts0.
Summary of Chapters
1 Introduction: This chapter introduces the problem of tax distortions and explains the transition from traditional optimal taxation to the challenges posed by multileveled government structures in a federal system.
2 Taxonomy of fiscal externalities: The chapter provides a classification of fiscal externalities, distinguishing between direct/indirect and horizontal/vertical forms, while justifying the focus on negative vertical externalities.
3 Why vertical fiscal externalities tend to cause inefficiently high tax rates: This section uses marginal cost analysis and the Laffer Curve to demonstrate how decentralized tax decisions lead to overtaxation when multiple government levels share a single tax base.
4 Development of an optimal tax policy to fiscal federalism: This chapter investigates solutions to the common pool problem, the application of Ramsey's rule for optimal tax design, and the optimal allocation of taxing powers.
4.1 How many levels of government should have the right to levy taxes?: This section discusses the benefits of allocating taxing powers to a single level to avoid the common pool problem.
4.2 How should the optimal tax policy be designed?: This part explains the application of the Ramsey inverse elasticity rule to minimize overall dead weight loss in a federal system.
4.3 Which level of government should excise taxes?: This section concludes that in the presence of heterogeneous states, decentralized tax collection is preferable to ensure efficient tax policy.
5 Concluding Remarks: The final chapter summarizes the findings, emphasizing that while vertical externalities are a primary concern, future research must incorporate the interplay between vertical and horizontal externalities.
Keywords
Fiscal Federalism, Vertical Fiscal Externalities, Optimal Taxation, Ramsey Rule, Common Pool Problem, Dead Weight Loss, Laffer Curve, Marginal Cost of Public Funds, Tax Base Overlap, Decentralization, Public Goods, Tax Policy, Elasticity, Intergovernmental Relations, Tax Competition.
Frequently Asked Questions
What is the core focus of this research?
The work primarily investigates the inefficiencies in tax policy that arise within federal systems when multiple levels of government have the power to tax the same base, leading to vertical fiscal externalities.
What are the primary themes discussed?
The central themes include the common pool problem, the distinction between vertical and horizontal externalities, optimal tax rate design using the Ramsey inverse elasticity rule, and the optimal distribution of taxing powers.
What is the main objective of the paper?
The objective is to identify why vertical externalities lead to inefficiently high tax rates and to determine how an optimal tax system can be structured to minimize the distortions caused by decentralized fiscal decision-making.
What methodology does the author employ?
The author uses a theoretical economic approach, utilizing graphical analysis (such as the Laffer Curve) and established models (like the Coase theorem and Ramsey's theory of taxation) to derive conditions for an optimal federal tax policy.
What is covered in the main section?
The main section details the taxonomy of fiscal externalities, the mechanics of how vertical spillovers cause high tax rates, and the practical application of optimal tax rules in federal systems.
Which keywords characterize this paper?
Key terms include Fiscal Federalism, Vertical Fiscal Externalities, Optimal Taxation, Ramsey Rule, and Common Pool Problem.
How does the "common pool problem" relate to federalism?
It acts as a fiscal analogue where multiple government levels compete for revenue from the same base, resulting in a collective overexploitation of that base and an underprovision of public goods.
Why is the Ramsey inverse elasticity rule significant here?
It provides a guideline for setting tax rates inversely to the price elasticity of tax bases, which is shown to be essential for minimizing the overall dead weight loss in a coordinated federal tax structure.
Does the author suggest that federal centralization is the solution?
No, the author concludes that due to the heterogeneity of states and the inability of a federal authority to differentiate rates, a decentralized approach where the state level possesses taxing power is more efficient.
- Citation du texte
- Dipl.-Kfm. Sebastian Krug (Auteur), 2011, Optimal Taxation in a Federal System of Governments, Munich, GRIN Verlag, https://www.grin.com/document/165499
