Trickling down or trickling away? Municipal fiscal responses to higher-level tax reforms

In many decentralized countries, local tax rates are set by local governments but are simultaneously linked to tax schedules that are determined by superior governments. In such systems, a change to the tax schedule by a superior level of government creates a vertical tax externality and affects local governments' budgets downstream. This raises the question whether federal tax changes provoke tax increases or other fiscal responses such as reductions of spending on the local level. In such a case, local government reactions eat away at the tax reform and its net effect might be different than anticipated by policymakers. To that end, I exploit a large-scale income tax cut in the Swiss canton of Bern to estimate a municipal response elasticity. I find that municipalities increase municipal tax disproportionately, resulting in higher municipal revenues and higher municipal spending. This implies a novel decentralization result such that municipalities' importance in taxation increases at the cost of cantonal importance. This response is much smaller when municipalities are more exposed to cross-municipal tax competition.