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Vertical Versus Horizontal Tax Externalities: An Empirical Test

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  • Marius Brülhart
  • Mario Jametti

Abstract

We study taxation externalities in federations of benevolent governments. Where different hierarchical government levels tax the same base, one can observe two types of externalities: a horizontal externality, working among governments of the same level and leading to tax rates that are too low compared to the social optimum; and a vertical externality, working between different levels of government and leading to suboptimally high tax rates. Building on the model of Keen and Kotsogiannis (2002), we derive a discriminating hypothesis to distinguish vertical and horizontal tax externalities based on measurable variables. This test is applied to a panel data set on local taxes in a sample of Swiss municipalities that feature direct-democratic fiscal decision making, so as to maximize the correspondence with the "benevolent" governments of the theory. We find that vertical externalities dominate - they are thus an observed empirical phenomenon as well as a notable extension to the theory of tax competition.

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Paper provided by McMaster University in its series Department of Economics Working Papers with number 2004-14.

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Length: 43 pages
Date of creation: 2004
Date of revision:
Handle: RePEc:mcm:deptwp:2004-14

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