REVENUE DECENTRALIZATION, THE LOCAL INCOME TAX DEDUCTION, AND THE PROVISION OF PUBLIC GOODS

Abstract

We consider a model where local and national governments both tax income and use the revenue to invest in both productive and consumptive public goods. Local governments will overprovide the consumptive public good if the local income tax is (partially) deductible. However, without full deductibility, local governments will underprovide local productive public goods. Hence, the central government will underinvest in both types of public goods. A national government that sets one national tax rate and provides transfers to the states results in lower welfare than one where states raise revenue, assuming the national government can set the local tax deduction.