Vertical Externalities in a Tax Setting in a System of Hierarchical Governments

Abstract

This paper focuses on the overlap in the tax bases between two levels of government. This overlap leads to vertical fiscal externalities that arise when several different commodities are in the tax base and the tax bases of the two levels of government may not be identical. In the unified government’s case, if it is supposed that the marginal utilities of income for the two states are the same, the tax policy in state i not only considers the price elasticity and cross elasticity of each state, but also the shares of expenditure on commodities x 1 and x 2 in the different states. When the cross elasticity is zero, the tax rates on the same commodity sold in the different states and the price elasticity should be inversely related. If the cross elasticity of the commodities is zero, the higher the marginal utility of income of state i , the lower should be the tax rate set by the unified government in state i .