The structure of authority, federalism, commitment and economic growth

Summary. In a neoclassical growth model with many regions and a mobile factor, two federal arrangements are considered. In the first federal arrangement the central government chooses a uniform tax policy, whereas in the second each regional government chooses its own tax policy. The main result is that the first federal arrangement leads to high tax rates and economic stagnation, whereas the second leads to low tax rates and economic growth. This result stems from a time consistency problem. The lack of tax competition forces a time consistency problem on the central government under the first federal arrangement. In contrast, regional tax competition acts as a commitment device under the second federal arrangement. The fundamental feature in the environment that gives rise to different abilities of the state to commit is the different structure of authority within the state.Received: 10 February 2003, Revised: 2 December 2003, JEL Classification Numbers: H77, O41, E60, C73, E13.Ronald A. Edwards: This is a revision of Chapter 3 of my University of Minnesota Ph.D. I thank my advisor Edward C. Prescott for his encouragement and numerous helpful discussions. I also thank Tim Kehoe for many useful discussions as well as Beth Allen, Berthold Herrendorf, Arilton Teixeira and two anonymous referees for helpful comments. This research was assisted by an International Predissertation Fellowship from the Social Science Research Council and the American Council of Learned Societies with funds provided by the Ford Foundation.