Strategic Interaction among Governments

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Strategic interaction among governments has recently become a major focus of theoretical and empirical work in public economics. One branch of the literature analyzes strategic interaction due to various kinds of “spillovers.” For example, in a model with pollution spillovers, the preferred level of abatement in one jurisdiction depends on policies chosen elsewhere (for a survey, see Wilson 1996). While other types of spillovers also lead to interaction, a different mechanism is at work in tax competition models, where governments levy taxes on a mobile tax base. Recognizing that their tax bases shrink as tax rates rise, large jurisdictions choose their rates in strategic fashion, with an eye on choices made elsewhere (for a survey, see Wilson 1999). A related body of literature focuses on “welfare competition,” analyzing income redistribution by state governments when the poor migrate in response to differentials in welfare benefits. In such models, states choose benefit levels in strategic fashion taking account of the mobility of the poor and the choices of other jurisdictions (for a survey, see Brueckner 2000). Spurred in part by these theoretical developments, strategic interaction among governments is now the focus of a growing empirical literature. Most studies in this literature test for strategic interaction by estimating reaction functions, which show how a jurisdiction responds to the choices of neighboring jurisdictions in setting the level of its own decision variable. If the estimated reaction function shows interdependence among policy choices, the presence of strategic interaction is confirmed. The purpose of this chapter is to provide an overview of conceptual issues in the theoretical and empirical literatures on strategic interaction. The discussion