Incomplete Information in Tax Setting of Local Governments: a Theoretical Framework

In the literature, tax interaction is mainly due to tax and yardstick competition. However, we suppose that tax interaction appears when the local policy maker conforms his fiscal policy to decisions taken by his neighbourhood to fill information gaps. Theoretical results show that incomplete information leads to tax mimicking and a higher level of tax rate. Moreover, leviathan governments are more sensitive than benevolent ones to changes in neighbours tax rates (horizontal tax interaction) but less to changes in the central government tax rate (vertical tax interaction). Finally, there is no tax rate internalization effects because an increase in the central government tax rate is not followed by an equivalent decrease of local government tax rate.