Interjurisdictional tax competition, provision of two local public goods, and environmental policy

This paper provides a model that integrates interjurisdictional tax competition and environmental policy. Each local government supplies two public goods - that benefit the local industry and the residents respectively - which are financed through distortionary taxation on industrial capital and pollutant emissions. In contrast to traditional theory of tax competition, we find that overprovision of local public goods may emerge in equilibrium. Since emission taxes serve to finance public spendings, the supply of public goods and the environmental quality are closely related. In the special case of a small region that cannot affect the national after-tax return to capital, we have the striking new result that in equilibrium two different regimes can occur. Either we have underprovision of public goods and an inefficiently high environmental quality, or we have overprovision of public goods and a too low environmental quality. These inefficiencies persevere as long as the federal government is not entitled to apply deliberate taxation/subsidy schemes. Correspondingly, unless regions are perfectly identical, we cannot hope to overcome the efficiency problem by symmetrical cooperative solutions.