Tax competition and tax coordination in a median voter model

Abstract

This paper analyzes the welfare effects of capital tax coordination in a simple model of fiscal competition where fiscal policy is subject to majority voting and households differ with respect to their labor and capital income. It turns out that a coordinated capital tax increase may raise or reduce welfare, depending on the relative magnitude of i) economic distortions induced by a labor tax and ii) political distortions resulting from the influence of the median voter on fiscal policy decisions. A negative welfare effect is more likely, the smaller the marginal excess burden of the labor tax and the smaller the ratio of the median voter's labor income to average labor income. We also use empirical estimates of the marginal excess burden of taxation to determine the welfare effects of tax coordination; it turns out that a negative welfare effect of coordinated tax increases may emerge in our model for empirically reasonable parameters.