Tax Competition

The Competition for a Mobile Tax Base

A number of researchers have argued that there are spillover effects across the budgets of local governments. For example, Oates (1972) suggested that competition for a mobile tax base, such as business investment, would force local governments to keep taxes and hence spending low, and that this downward bias is inefficient. Many papers have presented the argument in a formal model.

In particular, Zodrow and Mieszkowski (1986) presented a static model of capital allocation across a number of different locations where public spending is financed by a tax imposed on mobile capital and labor is immobile. The tax distorts the capital allocation decision. Each local government chooses the local tax rate on capital to maximize local welfare subject to its budget constraint.

The critical feature of the analysis is that each local government ignores the impact it has on other local governments. Under these conditions, the marginal cost of funds is greater than the marginal cost in magnitude. Zodrow and Mieszkowski showed that the level of a public good that confers a consumption benefit increases if greater reliance is placed on a non-distorting tax rather than a capital tax.

A plausible conjecture is that the tax rate on capital and spending on the public good are too low when the mobile factor is taxed because of competition among governments. In the situation where public capital improves productivity, this result is ambiguous. However, if an unusual instance can be ruled out, the result also holds with public capital.

The impact of one location’s tax system on another community can be thought of as an externality. When one local government raises its tax rate on mobile capital, some of the capital, and hence the tax base, moves to other locations. Such other locations benefit from the increases in their tax bases. Unfortunately, the first government does not consider this effect when choosing its optimal tax rate, a point that is true of each local government. It follows that each government tends to tax capital at too low a rate and provides fewer local public goods than otherwise.

Suppose the local government at location j raises its tax rate by dtj. The outflow of capital to other locations is dki/dtj and the flow of additional tax revenue is ti(dki/ dtj). If Sj is local government j’s subsidy, then dSJ/dtJ = Zi^jt^dki/dtj) is the marginal effect on the subsidy. Wildasin (1989) presented numerical examples indicating that the size of the subsidy and the marginal cost of public funds was substantial. For a reasonable benchmark case, the marginal subsidy rate is approximately 40%. Further, the social marginal cost of public spending, when the externality is taken into account, is approximately 70% of the actual cost as perceived by the local government when it ignores the externality. These results were derived in a partial equilibrium framework that implicitly assumed that the federal government had access to a non-distorting tax to finance the subsidy.

Sinn (1997) expressed extreme skepticism regarding the possibility that competition among local governments can essentially solve inefficiency problems, as the Tiebout hypothesis claims. The reason is that the problems confronting local governments exist because the private sector is incapable of solving them. Expecting competition among governments to solve inefficiency problems is perhaps asking too much. Sinn provided an example that involves public capital with congestion. Here, tax competition does not lead to an equilibrium where public capital is lower when private capital is taxed compared with when it is not taxed.

 
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