Local tax interaction with multiple tax instruments: evidence from Flemish municipalities

We investigate the long run result of strategic interaction among local jurisdictions using multiple tax instruments. Most studies about local policy interaction only consider a single policy instrument. With multiple tax instruments, however, tax interaction is more complex. We construct a simple theoretical framework based on a basic spillover model, with two tax rates and immobile resources. We show that the signs of within and cross tax interaction crucially depend on the extent to which a jurisdiction mimics the other jurisdiction’s budget, and the extent to which the preference for one tax instrument is affected by the level of the same or the other tax instrument in the other jurisdiction. Its specific institutional setting makes of Flanders (Belgium) a unique region to evaluate multiple tax interaction. Municipalities in Belgium are free to set two important local tax rates: the local property tax rate and the local income tax rate. We estimate whether years of strategic interaction between Flemish municipalities, of which the division is stable since 1983, has resulted in municipalities mimicking their neighbors’ tax structure. We do so by between estimating income and property tax reaction functions for the period 1992-2004, each of which simultaneously includes the neighboring municipalities’ income ànd property tax rate. We find that the property (income) tax rate of a municipality is significantly higher if the property (income) tax rate in other municipalities is high, and that the coefficient is higher if the possible impact of the other municipalities’ income (property) tax rate is accounted for. The cross impact of the other municipalities’ income (property) tax rate on the property (income) tax rate is always negative, though the significance is higher for the property tax than for the income tax reaction function. The result suggests that municipalities are keener on competing each other’s tax structure than on mimicking the neighboring municipalities’ budget.