DP6512 Does Tax Competition Tame the Leviathan?

Author(s):	Marius Brülhart, Mario Jametti
Publication Date:	October 2007
Keyword(s):	direct democracy, fiscal federalism, government preferences, optimal taxation, tax competition
JEL(s):	D7, H2, H7
Programme Areas:	Public Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=6512

We study the impact of tax competition on equilibrium taxes and welfare, focusing on the jurisdictional fragmentation of federations. In a representative-agent model of fiscal federalism, fragmentation among jurisdictions with benevolent tax-setting authorities unambiguously reduces welfare. If, however, tax-setting authorities pursue revenue maximization, fragmentation, by pushing down equilibrium tax rates, may under certain conditions increase citizen welfare. We exploit the highly decentralized and heterogeneous Swiss fiscal system as a laboratory for the estimation of these effects. While for purely direct-democratic jurisdictions (which we associate with benevolent tax setting) we find that tax rates increase in fragmentation, fragmentation has a moderating effect on the tax rates of jurisdictions with some degree of delegated government. Our results thereby support the view that tax competition can be second-best welfare enhancing by constraining the scope for public-sector revenue maximization.