Commuting in a Federation: Horizontal and Vertical Tax Externalities Revisited

Abstract

In this paper, commuting is introduced to a federal setting where an ad valorem residence based tax on labour income is decentralised. Under full decentralisation, this has lower-level (state) governments set inefficiently low taxes, even when households as a whole do not migrate. The motive of state governments is not to attract more workers, but to boost labour supply of own residents and hamper labour supplied by non-residents. When the labour tax base is co-occupied by the federal and state governments furthermore, either public under- or overtaxation may occur. Our model identifies clear conditions for states to overprovide, i.e. for the overall fiscal externality to be negative. Moreover, such a negative externality may arise even when the vertical as well as horizontal externalities are positive in isolation, and one would rather expect underprovision. Lastly, when states differ in terms of preferences and technology, an inflow of commuters makes it more likely for states to set taxes inefficiently low.