DP4593 Vertical versus Horizontal Tax Externalities: An Empirical Test

Author(s): Marius Brülhart, Mario Jametti
Publication Date: September 2004
Keyword(s): fiscal federalism, horizontal externalities, Swiss tax system, tax competition, vertical externalities
JEL(s): H10, H21, H25
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4593

We study taxation externalities in federations of benevolent governments. Where different hierarchical government levels tax the same base, one can observe two types of externalities: a horizontal externality, working among governments of the same level and leading to tax rates that are too low compared to the social optimum; and a vertical externality, working between different levels of government and leading to sub-optimally high tax rates. Building on the model of Keen and Kotsogiannis (2002), we derive a discriminating hypothesis to distinguish vertical and horizontal tax externalities based on observable variables. This test is applied to a panel dataset on local taxes in a sample of Swiss municipalities that feature direct-democratic fiscal decision making, so as to maximize the correspondence with the benevolent.governments of the theory. We find that vertical externalities dominate - they are thus an observed empirical phenomenon as well as a notable extension to the theory of tax competition.