Economic integration and interdependence of tax policy

This paper provides empirical evidence for interdependence of jurisdictions' tax policies. We study tax policy interdependence between municipalities in the economically integrated European Metropolitan Area Frankfurt/Rhein-Main, that spreads across two German states, Hesse, and Rhineland-Palatinate. For empirical identification, we exploit two reforms in the Hessian local fiscal equalization scheme in the 1990s that induced quasi-experimental variation in Hessian metropolitan municipalities' business tax rates. In response to the Hessian metropolitan municipalities' tax rate increase, Rhineland-Palatine metropolitan municipalities increase their local business tax rates more moderately as compared to a matched control group of Rhineland-Palatine non-metropolitan municipalities. We argue that primarily tax competition considerations drive the results, as the average tax-rate differential between metropolitan municipalities in Rhineland-Palatinate and Hesse stays stable during the analysis period. We conclude that an arguably strong economic integration of municipalities seems a key determinant for the interdependence of their tax policies.