Abstract
This paper focuses on the overlap in the tax bases between two levels of government. This overlap leads to vertical fiscal externalities that arise when several different commodities are in the tax base and the tax bases of the two levels of government may not be identical. In the unified government’s case, if it is supposed that the marginal utilities of income for the two states are the same, the tax policy in state i not only considers the price elasticity and cross elasticity of each state, but also the shares of expenditure on commodities x1 and x2 in the different states. When the cross elasticity is zero, the tax rates on the same commodity sold in the different states and the price elasticity should be inversely related. If the cross elasticity of the commodities is zero, the higher the marginal utility of income of state i, the lower should be the tax rate set by the unified government in state i.
Highlights
A federal structure of government involves at least two levels of government, a higher level as well as a set of lower level jurisdictions
We propose a theoretical model to explain how the federal government decides its tax policy when faced with vertical externalities in heterogeneous states
Based on (22), in the case where tax bases are identical, the tax rates on commodities, x1 and x2, in different states will depend on the price elasticity of demand, cross elasticity of demand, relative expenditures on commodities in each state and the social marginal rate of substitution between federal and state services or public goods, given the identical weights attached to each state government by the federal government, i.e
Summary
A federal structure of government involves at least two levels of government, a higher level as well as a set of lower level jurisdictions. Esteller-Moré and Rizzo (2011) [8] applied US data from 1975-2006 to propose that vertical tax competition can be estimated by using a federal tax variable that is expressed in real terms and shows cross-sectional variation across states. In their study, they test the impact of state taxes on gasoline and cigarettes of increases in federal excise taxes on these items, and provide evidence that an increase in the federal tax does not affect state tax rates in either case.
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