DP6431 Competing in Taxes and Investment under Fiscal Equalization

Author(s): Jean J.G. Hindriks, Susana Peralta, Shlomo Weber
Publication Date: August 2007
Keyword(s): equalization, fiscal, fiscal federalism, heterogeneous regions, public investments
JEL(s): C72, H23
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6431

The paper considers a model of federation with two heterogeneous regions that try to attract the capital by competing in capital income taxes and public investment that enhance the productivity of capital. Regions' choices determine allocation of capital across the regions and their revenues under a tax sharing scheme. This framework allows for the examination of different approaches to fiscal equalization schemes (Boadway and Flatters, 1982, and Weingast, 2006). We show that tax competition distorts (downwards) public investments and that the equalization grants discourage public investments with a little effect on equilibrium taxes. However, the equalization schemes remain beneficial not only for the federation and, under a low degree of regional asymmetry, also for each region.