Revenue Decentralization, the Local Income Tax Deduction, and the Provision of Public Goods

We consider a model where local and national governments invest in both productive and consumptive public goods using income tax revenue. Local governments will overprovide the consumptive public good if the local income tax is (fully or partially) deductible. However, without full deductibility, local governments will underprovide local productive public goods. Hence, to reduce the distortions in local governments’ decisions, a welfare-maximizing national government will underinvest in both types of public goods, assuming that the level of national public good provision does not directly affect the local governments’ decisions. We also consider an alternative fiscal structure where the national government sets one national tax rate and provides matching grants for expenditures on productive public goods; this can result in efficient levels of public good provision at both the local and national levels.