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 Policy

Link to this Page: www.cepr.org/pubs/dps/DP6512.asp.asp

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.