The Effect of Vertical Fiscal Imbalances on Local Tax Effort in Turkiye

This paper examines the role of vertical fiscal imbalances (VFI) on tax effort in Turkiye's 81 provinces over the period 2007-22, using linear and non-linear panel data models. We measure local tax effort, applying a panel stochastic frontier model to better address the endogeneity problem relative to previous studies. The same approach is employed to calculate VFI, focusing on the overall difference between expenditure needs and fiscal capacity of subnational jurisdictions. Our results indicate that the presence of VFI leads to decreases in tax effort at the provincial level. Subnational governments would appear to perceive transfer payments as a costless source of revenues as opposed to those coming from their own sources, leading to decreasing tax effort, both in the baseline and extension models. Moreover, we find that alternative measurements of transfer dependency are consistent with our findings. To further clarify the effect of transfer payments on subnational tax effort in a unitary country, we also apply dynamic panel threshold analysis. These results indicate that the overall effects depend on the degree of VFI. For VFI below a threshold value, transfer payments do not exert a constraining effect on subnational tax effort, but this is reduced when the VFI is above the threshold value.