Tax Competition and the Efficiency of "Benefit-Related" Business Taxes

The conventional wisdom in public finance is that local governments should finance public services, including those provided to businesses, with user charges that function as benefit taxes, and should in particular avoid inefficient source-based taxes on highly mobile capital. However, if user charges are not available or infeasible, several public finance experts have recently suggested that taxes on local production, such as an origin-based VAT, are a desirable alternative in that they serve as relatively efficient "benefit-related" taxes. We examine this contention formally in a model in which business public services must be financed with either a source-based tax on mobile capital, such as a property tax, or a tax on production, such as an origin-based VAT. In general, both a capital tax and a production tax are inefficient. However, consistent with the "benefit-related" view, the production tax is efficient if the production function belongs to the knife-edge case between log sub- and log supermodularity with respect to capital and public services (e.g., a Cobb-Douglas production function), while the capital tax results in underprovision of public services in this case. Similarly, if the production function is log submodular with respect to capital and public services (e.g., a CES production function with substitution elasticity greater than one), a production tax is again less inefficient than a capital tax, although both taxes result in underprovision of the public service. Finally, if the production function is log supermodular (e.g., a CES production function with substitution elasticity smaller than one), a production tax results in overprovision of the public service, while the effects of a capital tax--and thus the relative efficiency properties of the two taxes--are theoretically ambiguous.