Fiscal externalities and the design of intergovernmental grants

This paper describes the tax and expenditure externalities that can occur in a federation, focusing on the (relatively neglected) vertical tax and expenditure externalities which arise when state governments' tax and expenditure decisions affect the federal government's budget constraint and vice versa. Formulas are derived for matching grants which correct the distortions in governments' decision-making caused by fiscal externalities. With vertical tax externalities, the matching revenue grant may result in transfers from the state government to the federal government. With vertical expenditure externalities, the federal government should provide a matching expenditure grant equal to the additional federal revenue that is generated from an additional dollar spent by a state on productivityenhancing activities such as education.     

Fiscal equalisation schemes under competition

This paper considers optimal fiscal equalisation in a federation that competes with other federations for business tax base. It formalises the argument that, under certain circumstances, federations have an incentive to foster tax competition among their subunits in order to attract tax base from other federations. We show that optimal fiscal equalisation serves the purpose of redistributing income from rich to poor subunits and of choosing an optimal level of tax competition. The latter is chosen as a trade-off between three goals. First, decentralised tax rate setting has positive fiscal externalities within the federation and, thus, tax rates are inefficiently low. Second, in the presence of hold-up problems in investment, tax rates may be inefficiently high. Then, tax competition serves as a commitment device for low future tax rates and is, thus, welfare enhancing. Third, generous fiscal equalisation within the federation is a commitment to not aggressively compete with subunits outside the federation for tax base; as a consequence, with optimal equalisation, equilibrium tax rates are higher within and outside the federation—and even higher than in the case of centralised (i.e. federal level) tax rate setting.     

Local fiscal equalisation based on fiscal capacity: the case of Austria

This paper deals with local fiscal equalisation in Austria. The system of intergovernmental relations in Austria includes different regulations in order to equalise differences in the fiscal capacity of the municipalities. This leads to so‐called ‘compensation effects’, because additional revenues from a local government's own tax are (at least partly) compensated by losses from equalisation grants. This paper carries out a detailed analysis of these compensation effects. It is shown that they create strong fiscal disincentives for the local governments: on average, 55 per cent of additional revenues from the communal tax (which is the most important of a local government's own taxes) are compensated by losses of equalisation grants. In extreme cases, local governments can lose up to 144 per cent of the additional tax yields collected. These local governments would be better off if they made no effort to increase their tax base.     

Tax competition and tax base equalization in the presence of multiple tax instruments

The literature on tax competition has argued that tax base equalization, which reduces regional disparities in tax bases, can serve as a means of internalizing horizontal and vertical fiscal externalities. This argument assumes that each government relies on a single tax base (a regional tax on mobile capital and a federal tax on savings). This paper considers the case in which a distortionary labor tax is also available. Internalizing fiscal externalities requires that while the regional capital tax base is fully equalized, a region’s equalization entitlement for the labor tax is positive when its tax base is “larger” than the average tax base of all regions. This efficient tax base equalization system is incompatible with the primary objective of fiscal equalization.

     

Optimal Design of Intergovernmental Grants Under Asymmetric Information

This paper develops a theoretical explanation why it may be optimal for higher-level governments to pay categorical block grants or closed-ended matching grants to local governments. We consider a federation with two types of local governments which differ in the cost of providing public goods. The federal government redistributes between jurisdictions, but cannot observe the type of a jurisdiction. In this asymmetric information setting, it is shown that the second-best optimum can be implemented with the help of categorical block grants and closed-ended matching grants, but not with unconditional block grants or open-ended matching grants. JEL Code: H77, D82     

Federal tax competition and the efficiency consequences for local taxation of revenue equalization

Recent work has shown that a system of equalization grants can neutralize the efficiency loss caused by tax competition among lower-level governments. These models, however, ignore the vertical tax externalities that occur when the federal and lower-level governments levy taxes on the same base. This paper incorporates equalization grants into a standard capital tax competition model in which there are horizontal tax externalities between jurisdictions and vertical tax externalities between the levels of government. It is shown that, even in the presence of vertical tax externalities, an efficient level of lower-level government taxation can be achieved with a modifying version of a standard equalization grant formula.     

A Tax on Tax Revenue: The Incentive Effects of Equalizing Transfers: Evidence from Germany

Several recent studies suggest that equalizing transfers in a federal system may distort the tax policy decisions of states. We study this issue for the German federal fiscal system. In a simple theoretical model, we first identify a substitution effect and an income effect of equalizing transfers. Our main hypothesis is that both effects should tend to reduce tax revenue of German states. We perform various empirical tests which confirm this hypothesis.     

Tax Setting in a Federal System: The Case of Personal Income Taxation in Canada

In a decentralised tax system, the effects of tax policies enacted by one government are not confined to its own jurisdiction. First, if both the regional and the federal levels of government co-occupy the same fields of taxation, tax rate increases by one layer of government will reduce taxes collected by the other. Second, if the tax base is mobile, tax rate increases by one regional government will raise the amount of taxes collected by other regional governments. These sources of fiscal interdependence are called in the literature vertical and horizontal tax externalities, respectively. Third, as Smart (1998) shows, if equalisation transfers are present, an increase in the standard equalisation tax rate provides incentives to raise taxes to the receiving provinces. A way to check the empirical relevance of these hypotheses is to test for the existence of interactions between the regional tax rate, on the one hand, and the federal tax rate, the tax rate set by competing regions, and the standard equalisation tax rate, on the other hand. Following this approach, this paper estimates provincial tax setting functions with data on Canadian personal income taxation for the period 1982–1996. We find a significant positive response of provincial tax rates to changes in the federal income tax rate, the tax rates of competing provinces, and the standard equalisation rate (only for receiving provinces). We also find that the reaction to horizontal competition is stronger in the provinces that do not receive equalisation transfers.     

Efficiency and the optimal direction of federal-state transfers

It seems to be widely believed that the case for centralizing revenue-raising is stronger than that for centralizing expenditure decisions, so that federal governments should typically make transfers to lower-level (state) governments. This paper argues, however, that pure efficiency considerations may plausibly point in exactly the opposite direction. This arises because of a vertical fiscal externality: the typical state may neglect the impact that its tax decisions have on the federal tax base. The optimal federal response is to internalize this distortion of state decisions by means of offsetting subsidy on the common tax base, the financing of which may plausibly require transfers from the states.     

Revenue Sharing versus Expenditure Sharing in a Federal System

Problems of intergovernmental policy coordination can take many forms and are becoming increasingly important with continuing economic integration. In this paper we focus on the fiscal competition problem where the non-cooperative choice of taxes and transfers among governments typically leads to a suboptimal outcome. We look at the effect of two widely used corrective policies: revenue sharing and expenditure sharing (or intergovernmental matching grants). Our main result is that these two corrective policies have opposite effects depending on the form of competition between governments, namely whether governments compete in taxes or expenditures. More precisely, for any form of competition, revenue sharing is desirable exactly when expenditure sharing is not and vice versa. The implication is that the choice of the optimal corrective policy requires a complete understanding of the underlying non-cooperative behavior among governments. Our second main result is that neither revenue sharing or expenditure sharing can be sustained as a Nash equilibrium among governments, although all governments would benefit from one of these two corrective policies. Central intervention is therefore inevitable unless governments can pre-commit to the optimal corrective policy before setting their fiscal policies.     

疫情之下增强财政免疫力的思考

应对疫情的财政政策对财政自身的收支平衡产生很大的冲击,这更凸显了财政制度建设的重要性。本文认为,财政制度建设需要建立在以下六个认识基础上:国家需要与其经济发展阶段相匹配的财力;税收成本一般低于其他形式财政收入;税收第一位功能是筹集财政收入,而不是其他;通过国有企业支撑财政不是长久之计;提高财政透明度、加强财政预算审查是财政提质增效的最好办法;财政改革最终落脚到现代治理观念和方式的变革。     

Optimal fiscal policy with environmental tax and pollution abatement spending in a model with utility-enhancing environmental quality: lessons from Bulgaria

This paper characterized optimal fiscal policy in the presence of pollution, and evaluated it relative to the observed one in Bulgaria. To this end, a dynamic general-equilibrium model is calibrated to Bulgarian data. The main findings are: (i) The optimal steady-state income tax rate is zero; (ii) the benevolent Ramsey planner provides 20% higher utility-enhancing environmental quality; (iii) the optimal level of carbon taxes is almost three times higher, and the optimal level of abatement spending is six times higher; (iv) the optimal steady-state consumption tax is twice lower.     

Fiscal federalism and local public finance: A computable general equilibrium (CGE) framework

This paper attempts to make an argument for the feasibility and usefulness of a computable general equilibrium approach to studying fiscal federalism and local public finance. It begins by presenting a general model of fiscal federalism that has at its base a local public goods model with (1) multiple types of mobile agents who are endowed with preferences, private good endowments, and land endowments, (2) local governments that produce local public goods funded by a property tax, and (3) a land market that capitalizes local policies to equilibrate supply and demand. To this, a state (or national) government producing a state public good is added, and all levels of government abide by majority rule voting. A computable general equilibrium framework is derived from this theoretical model and calibrated to New Jersey micro tax data. It has been applied elsewhere to study the dominance of property in local tax bases as well as the general equilibrium effects of state or national intergovernmental programs such as redistributive grants in aid, district power equalization, and the deductibility of local taxes. Results in these areas are summarized and potential future applications discussed.     

Can fiscal equalisation mitigate tax competition? Ad valorem and residence-based taxation in a federation

In this paper, we revisit the combined effect of horizontal and vertical tax externalities in a federal context, extending the theoretical framework of Keen and Kotsogiannis (Am Econ Rev 92(1):363–370, 2002) by allowing for ad valorem and residence-based taxation. When taxes are levied ad valorem rather than per-unit firstly, we find the interaction between both types of externalities is more ambiguous than commonly understood. As a result, and contrary to earlier findings, fiscal equalisation mechanisms such as the representative transfer system (RTS) fail to fully internalise the tax externalities. Given these limitations, we derive the conditions under which a standard RTS will either: (1) at least nudge politicians in the right direction; (2) realise no welfare gains at all; (3) considerably overshoot the second-best efficiency mark causing welfare loss. Lastly, we find that when taxation is residence-based rather than source-based, a different kind of competition emerges where tax cuts are aimed at stimulating outward factor flows, rather than attracting inward flows.     

Optimal money and debt management: Liquidity provision vs tax smoothing

Conventional wisdom on public debt management says that liquidity demand should be satiated and that tax rates should be smoothed. Conflicts between the two can arise when government bonds provide liquidity. Smoothing taxes causes greater variability in fiscal balances, and therefore in the supply of government liabilities. When prices are flexible, and can jump to absorb fiscal shocks, the tradeoff between liquidity provision and tax smoothing is eased; when they conflict, optimal policy subordinates tax smoothing to satiating liquidity demand. When price fluctuations impose real costs, conflicts necessarily arise and optimal policy gives primacy to neither goal.     

Fiscal Effects of Block Grants for the Needy: An Interpretation of the Evidence

In 1996 the United States revamped its welfare system by eliminating the entitlement to cash benefits under Aid to Families with Dependent Children (AFDC), and replacing it by Temporary Assistance to Needy Families (TANF). Federal financing was converted from open-ended matching grants to fixed block grants. This paper reviews the evidence on the likely impact of block grants for the needy on average benefit levels, total redistributional outlays, and on differentials across states. The econometric evidence on state responses to federal incentives for spending on the needy varies enormously. An evaluation of this evidence, together with an examination of state responses to the federalization of aid to the elderly, blind, and disabled through the Supplementary Security Income program, suggests that in the long run the federal changes will substantially decrease the amount of direct cash redistribution in the United States. A reasonable guess is that average benefits to the needy will be 15 to 30 percent smaller than under current law, while total spending on cash grants could decline by as much as 35 percent. While interstate competition will act to reduce benefit differentials across states, this tendency will be offset by differential matching rate effects. An extreme race to the bottom, with a total withering of the transfer state, is unlikely to occur.     

General-equilibrium effects of investment tax incentives

A new-Keynesian model with a nominal tax system is developed and used to study the macroeconomic effects of temporary tax-based investment incentives. Two claims regarding the effects of these incentives are examined: first that they are overstated in partial-equilibrium frameworks; and second that repeated use of such incentives by policymakers can ultimately be destabilizing. The results contradict the first claim and imply that the second claim is not general. The model is also used to compute the predicted effects of an investment tax incentive that has figured prominently in recent fiscal stimulus packages.     

The assignment and division of the tax base in a system of hierarchical governments

Vertical externalities, changes in one level of government’s policies that affect the budget of another level of government, may lead to non-optimal government policies. These externalities are associated with tax bases that are shared or “co-occupied” by two levels of government. Here I consider whether co-occupancy of tax bases is desirable. I examine the optimal extent of the tax bases of a lower level of government (local) and a higher level (state). I find that it is optimal to have co-occupancy in the absence of other corrective policies if commodities in the tax bases are substitutes. Further, if the state government can differentially tax the co-occupied segment of the tax base and the segment it alone taxes it will obtain the (second-best) outcome obtained with other policy instruments such as intergovernmental grants.     

Value-added tax options for India

The pressures of aggregate revenue, the requirement of a reduced role for customs duties for the liberalization of the economy, and the complexity and strains of the current system together point clearly toward the desirability of tax reform in India. Since domestic indirect taxes provide the major source of revenue, they deserve special attention. This paper argues that India would benefit from moving toward a system of value-added taxation (VAT) and focuses on the way in which a VAT (or VATs) can be best introduced into India given the country's federal structure. Three different options are distinguished: a central VAT, dual VAT, and states' VAT. We argue that the first is politically infeasible, that the second represents the best way forward in the short term, and that the third deserves consideration as a long-run option. Special attention is paid to the problems that would arise under either a states' or a dual VAT with regard to taxing interstate trade.     

两税法改革的历史借鉴

两税法在中国财税史上留下了浓墨重彩的一笔,其在财税体制方面的经验与教训值得我们深思。本文基于财税体制的考察视角,并结合全面推进营改增的时代背景,从两税法的产生原因、改革内容、各方影响等方面进行考察,以期为当前的财税体制改革提供一定的历史借鉴。