Tax Setting in a Federal System: The Case of Personal Income Taxation in Canada

In a decentralised tax system, the effects of tax policies enacted by one government are not confined to its own jurisdiction. First, if the tax base is mobile, tax rate increases by one regional government will raise the amount of taxes collected by other regional governments (horizontal tax externality). Second, if both the regional and the federal levels of government co-occupy the same fields of taxation, tax rate increases by one layer of government will reduce taxes collected by the other (vertical tax externality). Third, as Smart (1998) shows, if equalisation transfers are present, an increase in the standard equalisation tax rate provides incentives to raise taxes to the receiving provinces. In order to check the empirical relevance of these hypotheses, this paper estimates provincial tax setting functions with data on Canadian personal income taxation for the period 1982-96. We find a significant positive response of provincial tax rates to changes in the federal income tax rate, the tax rates of competing provinces, and the standard equalisation rate (only for receiving provinces). We also find that the reaction to horizontal competition is stronger in the provinces that do not receive equalisation transfers.