Vertical Externalities Research Articles

Corporate taxes and vertical tax externalities: Evidence from narrative federal tax shocks

The empirical aspects of vertical tax externalities have been studied fairly extensively, but with little consensus – a fact that may relate to difficulties in isolating exogenous components in tax setting policy. Adopting the case of the US and using a narrative approach (Romer and Romer, 2010), I study the vertical effects of federal tax shocks. I find that vertical tax externalities are modest in their size and are only present in corporate taxation. In particular, I estimate that a $1 billion increase in federal tax revenues reduces total state corporate tax revenues by approximately $27 million. Non-corporate state tax revenues do not seem to be affected by federal tax shocks. Taking a state micro-level approach and using firm-level business activity data, I show that the findings point to the erosion of states’ corporate tax bases.

The assignment and division of the tax base in a system of hierarchical governments

Vertical externalities, changes in one level of government’s policies that affect the budget of another level of government, may lead to non-optimal government policies. These externalities are associated with tax bases that are shared or “co-occupied” by two levels of government. Here I consider whether co-occupancy of tax bases is desirable. I examine the optimal extent of the tax bases of a lower level of government (local) and a higher level (state). I find that it is optimal to have co-occupancy in the absence of other corrective policies if commodities in the tax bases are substitutes. Further, if the state government can differentially tax the co-occupied segment of the tax base and the segment it alone taxes it will obtain the (second-best) outcome obtained with other policy instruments such as intergovernmental grants.

Retailer and manufacturer advertising scheduling in a marketing channel

This paper investigates, in a bilateral monopoly, the optimal scheduling of retailer and manufacturer advertising in a three-period planning horizon. Consistent with previous literature, the integrated channel adopts continuous advertising schedules when advertising effects are not very large and decay exponentially over time. Conversely, when pricing and advertising decisions are uncoordinated, vertical externalities also influence advertising scheduling. Consequently, channel members can optimally implement each of the following three advertising schedules depending on the effects of retailer and manufacturer advertising: The full continuous schedule, in which channel members advertise in the three periods; the full pulsing schedule, in which the two channel members advertise only in the first and third periods, and the mixed schedule where the retailer continuously advertises and the manufacturer advertises exclusively in the first and third periods. Surprisingly, the uncoordinated channel adopts lower retail prices than the integrated channel when the mixed schedule is adopted.

Assessing the profitability of cooperative advertising programs in competing channels

A large literature studied the profitability (effectiveness) of cooperative advertising programs (CAPs) in distribution channels, but very few studies modeled pricing decisions in competitive markets under different channel structures. This paper fills this gap. We propose a game-theoretic model where two competing channels make pricing and promotional decisions. The effectiveness of CAPs is studied under different channel structures to examine how vertical and horizontal externalities can impact the effectiveness of CAPs. Each channel structure can be integrated or decentralized to account for different vertical interaction effects, resulting in three cases: (i) both channels are decentralized (DD), (ii) both are integrated (II), and (iii) a hybrid structure where one channel is decentralized and is competing with an integrated channel (DI). We solve six non-cooperative games: (1) both manufacturers offer CAPs under DD, (2) only one manufacturer offers a CAP under DD, (3) both manufacturers do not offer CAPs under DD, (4) the decentralized manufacturer offers a CAP under DI, (5) the decentralized manufacturer does not offer a CAP under DI, and (6) the channel problem under II. Then, we obtain and compare equilibrium profits and strategies across these games. The main results indicate that the profitability of CAPs depends on the levels of price competition and of the advertising effects. Also, while manufacturers benefit from CAPs, retailers may not find such programs profitable. Finally, the decentralized or integrated structure of the competing channel significantly impacts the effects of cooperative advertising. For example, CAPs can effectively coordinate the DD channel and even help it exceed profits earned by a vertically integrated channel. However, in the DI case, although CAPs can improve total channel profits, they do not fully coordinate the channel.

The Decentralization of Social Assistance and the Rise of Disability Insurance Enrolment

Fiscal decentralization, the decentralization of government expenditures to local governments, may enhance public sector efficiency. Vertical externalities, i.e. spillovers between local and central government, could however undo part of this advantage. In this paper we estimate spillovers from Social Assistance (SA), administered by municipalities, towards central government’s Social Security Disability Insurance (SSDI) scheme in The Netherlands. The latter scheme saw rapidly rising enrolment rates after financial responsibility for Social Assistance was transferred from central to local government. We find that the correlation between local SSDI enrolment and the local stock of SA benefits recipients has increased significantly in the years after decentralization. We show that an increased caseload shifting from Social Assistance to Disability Insurance is the only plausible explanation for this change. Our analysis shows that, following the decentralization of Social Assistance, at least one third of the SSDI inflow was diverted from SA. This caseload shifting increased more rapidly in municipalities experiencing deficits on their SA budgets than in municipalities running a surplus.

Can fiscal equalisation mitigate tax competition? Ad valorem and residence-based taxation in a federation

In this paper, we revisit the combined effect of horizontal and vertical tax externalities in a federal context, extending the theoretical framework of Keen and Kotsogiannis (Am Econ Rev 92(1):363–370, 2002) by allowing for ad valorem and residence-based taxation. When taxes are levied ad valorem rather than per-unit firstly, we find the interaction between both types of externalities is more ambiguous than commonly understood. As a result, and contrary to earlier findings, fiscal equalisation mechanisms such as the representative transfer system (RTS) fail to fully internalise the tax externalities. Given these limitations, we derive the conditions under which a standard RTS will either: (1) at least nudge politicians in the right direction; (2) realise no welfare gains at all; (3) considerably overshoot the second-best efficiency mark causing welfare loss. Lastly, we find that when taxation is residence-based rather than source-based, a different kind of competition emerges where tax cuts are aimed at stimulating outward factor flows, rather than attracting inward flows.

What Drives Vertical Fiscal Interactions? Evidence from the 1980 Crude Oil Windfall Act

What drives vertical tax externalities? Previous studies focused on the standard common-pool problem. In this paper we study a new potential channel: complementarities between state and federal public goods. First, we illustrate its potential key role in determining the sign of the vertical reaction through a standard model of horizontal tax competition with vertical fiscal interactions. Second, we propose a novel strategy for identifying it, by considering an empirical design that confines the common-pool channel to specific locations. We implement this design through a quasi-natural experiment: the 1980 U.S. Crude Oil Windfall Act, which increased federal tax collections from sale of crude oil, thereby affecting the tax base of oil rich states specifically. This latter feature enables attributing the vertical fiscal reactions of the remaining states to the complementarity channel. Following this strategy, we decompose the vertical tax externalities arising from this federal tax change, and find that: (i) state and federal public goods are, on average, complementary, with complementarity being most apparent in transportation-related expenditures; (ii) the complementarity channel takes a considerable share in the overall vertical fiscal reaction, approximately 60% in the majority of our estimates; (iii) both the complementarity and common-pool effects increase state tax rates; (iv) complementarity (common-pool) affects state corporate (property) tax rates most strongly.

Spillover Effects in a Federal Country with Vertical Tax Externalities

We analyze how spillover effects may affect the choice of a federal tax rate in a federal country with vertical tax externalities. Our main result shows the conditions under which the federal tax rate with spillover effects is lower or higher than the federal tax rate without spillover effects. The effects of vertical tax externalities can be modified by the reaction of the federal government to the horizontal externality due to spillover effects.

Vertical fiscal externalities and the environment

We show that imposition of a state-level environmental tax in a federation crowds out pre-existing federal taxes. We explain how this vertical fiscal externality can lead unilateral state-level environmental policy to generate a welfare gain in the implementing state, at the expense of other states, even absent any environmental benefits. Using a computable general equilibrium model of the Canadian federation, we show that vertical fiscal externalities can be the major determinant of the welfare change following environmental policy implementation by a state government. Our numerical simulations indicate that – as a consequence of vertical fiscal externalities – state governments can reduce greenhouse gas emissions by over 20 percent without any net cost to themselves.

The Assignment and Division of the Tax Base in a System of Hierarchical Governments

The existence of either horizontal fiscal externalities, in which changes in one jurisdiction's policies affect the government budget of other jurisdictions and therefore the utility of its residents or externalities, in which changes in one level of government's policies affect the budget of another level of government, may lead to non-optimal government policies. These fiscal externalities, then, suggest the possibility of corrective policies. The focus here is on vertical externalities. In a growing literature, these externalities are associated with the extent that tax bases are shared or co-occupied by two different levels of government. Given that co-occupancy is the cause of or at least exacerbates the externality, I consider, the optimal assignment of the tax base and, more specifically, whether the co-occupancy of tax bases is desirable. Specifically, I examine the optimal extent of the tax base of a lower level of government (local) and a higher level (state) in a hierarchical system of governments. The co-occupancy of the tax base influences the magnitude and possible the direction of fiscal externalities associated with the taxes of one or both of the levels of government. Using a model in which there is a continuum of commodities, each with the same demand characteristics, I formally consider whether, as has been asserted in a number of studies, whether it is optimal to eliminate all co-occupancy between the tax bases of the two levels of government. While I find that it is indeed not optimal to have co-occupancy in the tax base in the absence of other corrective policies for the fiscal externality, eliminating co-occupancy does not, in general, eliminate fiscal externalities, meaning that tax rates can still be above or now below the socially-optimal level. Thus elimination of co-occupancy in the tax base is not a substitute for a policy such as intergovernmental matching grants which directly eliminates fiscal externalities. If alternative policies are available such as matching grants that do eliminate fiscal externalities and governments are restricted to set the same tax rate on all commodities in their base, the optimal division of the tax base changes dramatically -- optimality requires both governments tax the entire base. (JEL H77 - Intergovernmental Relations; Federalism)

Does Revenue Equalisation Mitigate Tax Competition? Ad Valorem Taxation in a Federation

In this paper, we model a federal economy where perfectly mobile labour supply is taxed on an ad valorem basis by the federal as well as lower-level (state) governments. We find that either under- or overtaxation occurs, under similar conditions as in Keen and Kotsogiannis (2002, 2004). However, the neat trade-off between positive horizontal externalities and negative vertical externalities breaks down entirely in our ad valorem setting. Precisely because of this ambiguity, decentralizing the unitary outcome via revenue equalisation becomes far more complex than under unit taxation. Only when the marginal valuation of public provision is on par with private consumption, can we replicate the clear-cut, efficiency-enhancing equalisation formulas given by Kotsogiannis (2010) and Bucovetsky and Smart (2006).

Heterogeneous Vertical Tax Externalities, Capital Mobility, and the Fiscal Advantage of Natural Resources

How do state tax rates respond to federal tax shocks? This paper presents a novel mechanism of heterogeneous vertical tax externalities across levels of fiscal advantage, showing that tax increases can be expansionary -- even without their reinvestment. States rich in natural resources have a fiscal advantage in the inter-state competition over production factors which allows them to respond better to increases in federal taxes and, consequently, attract capital from other parts of the nation. We add heterogeneity in fiscal advantage levels to an otherwise standard model of vertical tax externalities and horizontal tax competition. The model shows that, irrespective of federal redistribution, the contractionary effect of a federal tax increase can be overturned in resource-abundant states, through an increase in their tax base. Using the case of the U.S., and narrative-based measured federal tax shocks a-la Romer and Romer (2010), we provide empirical evidence for the various aspects of this mechanism. Specifically, our lower-bound estimates indicate that, controlling for federal transfers, a 1% increase in the GDP share of federal taxes at the beginning of a year increases the growth rate of the per capita tax base by approximately 16% in high fiscal advantage states at the end of it.

Knowledge externalities and demand pull: The European evidence

This paper elaborates the microeconomic foundations of the demand pull hypothesis stressing the role of vertical knowledge externalities stemming from user–producer knowledge interactions that parallel vertical transactions. The paper articulates and tests the hypothesis that such competent demand is actually able to pull technological change only when it is expressed by advanced users, able to provide relevant knowledge externalities to their customers. Using input output tables we test empirically this hypothesis for 15 European countries in the years 1995–2007. The evidence confirms that the increase in productivity of the upstream sectors is positively influenced by the sector-level derived demand, according to the upstream rates of introduction of innovations and to the intensity of the user–producer interactions. The policy implications of the analysis enable to elaborate and implement the notion of a ‘competent’ public demand.

Federalism with Bicameralism

Abstract We analyse how bicameralism can affect national fiscal policies in a federal country when vertical and horizontal externalities interact. Conditions are provided to show when, at equilibrium, the two chambers agree or disagree on the choice of a national capital tax rate, depending on whether or not the pivotal voter in the two chambers is the same.

Vertical or Horizontal: Endogenous Merger Waves in Vertically Related Industries

Abstract Endogenous merger waves are studied in vertically related industries where firms may engage in both vertical and horizontal mergers. It is shown that whether and how firms merge depends crucially on the balance between vertical and horizontal externalities, and the balance between upstream and downstream competition. Furthermore, firms may merge with or without any fundamental change in the underlying economic conditions.

A structural multisectoral model with new economic geography linkages for Tuscany

AbstractThis paper describes the Remi‐Irpet macroeconometric multisectoral model. The Remi‐Irpet, based on an input‐output core structure, has its most distinctive feature in the modelling of vertical pecuniary externalities à la Fujita‐Krugman‐Venables which represents the core dynamization mechanism. Our contribution first presents the theoretical background of the model. Second, we present a simulation exercise performed through the model in which we evaluate the structural impact of incoming FDIs for Tuscany. The impact analysis is defined in terms of (i) change in the overall productive capacity and (ii) medium‐term changes in prices and productivity, driven by the changes in the accessibility to labour and intermediate inputs.

Vertical Fiscal Externalities and the Environment

Vertical Fiscal Externalities and the Environment

Corporate Tax Shocks as Drivers of Vertical Tax Externalities: Evidence from Narrative Federal Tax Shocks

Corporate Tax Shocks as Drivers of Vertical Tax Externalities: Evidence from Narrative Federal Tax Shocks

Commuting in a Federation: Horizontal and Vertical Tax Externalities Revisited

In this paper, commuting is introduced to a federal setting where an ad valorem residence based tax on labour income is decentralised. Under full decentralisation, this has lower-level (state) governments set inefficiently low taxes, even when households as a whole do not migrate. The motive of state governments is not to attract more workers, but to boost labour supply of own residents and hamper labour supplied by non-residents. When the labour tax base is co-occupied by the federal and state governments furthermore, either public under- or overtaxation may occur. Our model identifies clear conditions for states to overprovide, i.e. for the overall fiscal externality to be negative. Moreover, such a negative externality may arise even when the vertical as well as horizontal externalities are positive in isolation, and one would rather expect underprovision. Lastly, when states differ in terms of preferences and technology, an inflow of commuters makes it more likely for states to set taxes inefficiently low.

Overlapping Local Government Debt and the Fiscal Common

In a complex federalist system, the interactions across levels of government have important fiscal implications. Municipal debt has become increasingly important as local governments turn to tax-backed bonds as a significant source of funds. In a system of local governments that have overlapping borders, fiscal interactions become a factor in issuing debt. In this system, debt acts as a fiscal common resource similar to traditional common-pool resources. Specifically, vertical externalities are created with multiple levels of governments issuing bonds backed by the same tax base. Empirical results show that on average an increase in the total amount of debt issued by subcounty governments increases the true interest cost paid by county governments on tax-backed debt. Furthermore, increasing the number of overlapping governments also increases the interest costs for county debt. These findings show support for analyzing debt capacity as a fiscal common resource and have implications for debt management strategies.