Tax competition in federations and the welfare consequences of decentralization
Paper number: 02/01
Paper date: February 26, 2002
Paper Category: Working Paper
Michael J Keen and Christos Kotsogiannis
This paper explores the impact of intensiﬁed tax competition within federal systems characterized by the presence of both horizontal tax externalities between the states and vertical tax externalities between states and federal government. It shows that although these point in opposite directions (horizontal towards state taxes that are too low, vertical towards state taxes that are too high), leaving the net outcome unclear, intensiﬁed tax competition always worsens their combined eﬀect. That is, intensiﬁed lower-level tax competition—in the form of an increase in the number of lower-level jurisdictions—is sure to reduce welfare, but this is not because, as usually supposed, it makes excessively low state taxes even lower; rather, it is welfare-reducing either for that reason or because it makes excessively high state taxes even higher.