Decentralizing Taxation and Public Expenditure within a Federation

Abstract

A model of a central government and two local governments is used to study the role of fiscal federation in reducing the effect of revenue externalities between local jurisdictions. Immobile consumers buy goods in both their own and the other local community and pay sales taxes in each community. Depending on demand parameters, the fiscal externality may be positive or negative. In the former case, the local governments set tax rates below those a central government would choose. With a positive revenue externality, the central government can use the same tax bases as local governments to finance revenue sharing grants, stimulating local public expenditure, and thus raising welfare. If communities are heterogeneous, this revenue sharing system will not be fully optimal, but it can dominate a system of exclusive central revenue collection.