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Vertical versus Horizontal Tax Externalities: An Empirical Test

  • Brülhart, Marius
  • Jametti, Mario

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 sub-optimally 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 observable variables. This test is applied to a panel dataset 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 C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4593.

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Date of creation: Sep 2004
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Handle: RePEc:cpr:ceprdp:4593
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