A New Approach to Estimating Tax Interactions in Fiscal Federalism

The purpose of this paper is to propose a new approach to empirically analyze the existence of strategic interactions of taxation between state governments (horizontal) and between state and federal governments (vertical) using gasoline and cigarette taxation in the U.S. I explicitly estimate the structural parameters of consumer's utility and state governmentfs objective functions. The slopes of the reaction functions, which represent the strategic interactions of state government taxation policies, are then computed given the estimated structural parameters. Empirical results show that contrary to the existing literature, there is very little horizontal tax interaction in both the gasoline and cigarette cases. On the other hand, there is a moderate positive vertical tax interaction for both gasoline and cigarette taxes and the scale is larger in the case of cigarette taxes. Furthermore, the value and sign of the slopes of the reaction function are very different across states. This suggests a new policy implication: as state governments respond differently to federal government fiscal policy, uniform fiscal policy is not appropriate for welfare maximization of the nation.