Panel Paper: Inter-Federation Competition: Sales Tax Externalities with Multiple Federations

Saturday, November 10, 2012 : 8:50 AM
Jefferson (Sheraton Baltimore City Center Hotel)

*Names in bold indicate Presenter

David Agrawal, University of Georgia

Existing models of tax competition focus on intra-federation competition. This paper analyzes how introducing inter-federation competition affects the strategic nature of tax competition. In the context of a Nash equilibrium, the paper shows that lower levels of government will respond differently to higher levels of government depending on the local government's position within the federation -- specifically whether the locality is internal or peripheral relative to the federation's borders. Inter-federation competition will also introduce “diagonal externalities,” which are fiscal externalities between neighboring jurisdictions, but that occur between different levels of government. A diagonal externality will have similar effects as a horizontal externality. The paper uses two unique data sets, a cross-section of all local tax rates in the United States and spatial proximity data, to test how local governments react to horizontal, vertical, and diagonal competitors. The empirical specifications allow for vertical and horizontal externalities to have interaction effects and allow for strategic reactions that vary based on proximity to neighboring federations. If interaction effects and distance based effects are omitted from the estimating equation, the vertical strategic reaction will be approximately 30% too large in absolute value. After including these terms, a one percentage point increase in the county tax rate implies that municipal tax rates in the county will be approximately 0.60 percentage points lower. Taxes in neighboring jurisdictions have a large and positive effect.

Full Paper: