Leviathan and Capital Tax Competition in Federations

This paper analyzes a simple model of taxation in a federal system within which policymakers are revenue–maximizing Leviathans and fiscal externalities arise not only horizontally, across the "states," but also vertically between levels of government. Such an economy is characterized by excessively high taxation in the noncooperative equilibrium. Intensifying horizontal competition, by increasing the number of states, unambiguously increases revenues (contrary to the Leviathan wisdom) but nevertheless enhances consumer welfare (consistent with the Leviathan wisdom). Revenue sharing arrangements between policymakers are shown to be—contrary to the Leviathan wisdom—Pareto improving.