The Principle of Local Tax
The Overlapping Tax Base
One interesting feature of intergovernmental financing is that central and local governments may impose the same tax base. This is called the overlapping tax base and tax revenue. Suppose the tax rate is fixed; then, an increase in the tax base has a positive spillover effect on the other governments’ revenue. There is a vertical externality of public investment because of the overlapping tax base. Consequently, more local public investment means an increase in the revenue of the central government; hence, the central government may subsidize the local government further.
With regard to the competition among governments, it is useful to differentiate horizontal externality from vertical externality. Horizontal externality among governments means that many governments in different regions tax the same tax base. In this situation, tax competition results in tax rates that are too low, as explained in the prior section. However, vertical externality among governments means that the central government and the local government impose the same tax base at the same time.
In this circumstance, tax competition on the overlapping tax base results in tax rates that are too high. Vertical externalities are likely to leave local taxes too high because each local government unduly discounts the pressure on central government’s spending that it creates by raising its own tax rate. In order to cope with vertical externality, it may be desirable for the central government to impose the standard rate for local taxes so as to set a limit for raising taxes.