Optimal Taxation in a Federal System of Governments

Abstract

This paper demonstrates that the optimal structure of taxation in a federal system of governments is one in which only lower level governments are allowed to tax, and the higher level of government receives its revenues as contributions from the lower level governments. The central inefficiency created when multiple levels are allowed to tax is a revenue externality between governments that is analogous to a common pool problem. A federal system with multiple levels of taxing authority results in combined tax rates higher than would be optimal, a higher excess burden of taxation, and an inefficiency bias in government spending. Within a federal system of governments there are several ways to allocate the power of taxation to provide revenues for all levels of government. The current structure in the United States (U.S.) gives federal, state, and local governments the power to tax individual citizens. Commonly there are more than three levels of taxing authority if special districts are included. The current literature on optimal taxation contains little consideration of how the power of taxation should be allocated in a federal system, and instead concentrates on the best way for a single government to raise revenue across its tax instruments. This issue is also directly relevant to whether international organizations, such as the United Nations (U.N.) or European Union should have the power of taxation. This paper demonstrates that allowing multiple levels of government the power of taxation creates a common pool problem, with the result being that the combined tax rates of all governments are higher than would be optimal. The central idea is that a change in the tax rate of one level of government affects the revenues of other levels of government, resulting in an intergovernmental revenue externality. The adverse effects of allowing multiple levels of government the power of taxation are an increase in the deadweight loss of taxation, an inefficiency bias in government spending, and possibly lower total tax revenue. After showing these results, I discuss alternative taxing institutions to internalize the externality. In this paper I argue that the system where only states have the power of taxation, and the federal government is financed through a system of contributions from the state governments, is the strictly preferred system of taxation in a federal system of governments. The feasibility of this solution is discussed within the context of the fiscal system that was present