Federal Tax Competition and the Efficiency Consequences for Local Taxation of Revenue Equalization

Recent work has shown that a system of equalization grants can limit tax competition among lower-level governments. The structure of such models, however, does not allow for the federal to be an active player but its role is being limited in the administration of the equalization grants. The implication of this is that potentially important, for the efficiency properties of lower-level government taxation, vertical fiscal externalities are ignored. This paper introduces equalization grants into a standard federal capital tax competition model in which fiscal externalities arise not only horizontally, between jurisdictions, but also vertically between the levels of government. It is shown that, even in the presence of vertical fiscal inefficiencies, efficiency in the level of lower-level government taxation can be achieved by a modifying version of a standard equalization grant formula.