Optimal Formulas for Subnational Tax Revenue Sharing

Abstract

We develop an analysis of optimal formulas for subnational tax revenue sharing for two cases of interest: when local public goods (lpg’s) show spillovers and are inter-regional perfect and imperfect substitutes. Our analysis could be relevant to understand the determinants of feasible competing alternatives for the design of tax revenue sharing systems. Our study shows that: 1) Inter-regional spillovers should be taken into account in the design of formulas for subnational revenue sharing when lpg’s are perfect inter-regional substitutes but should not be taken into account to supply lpg’s that are imperfect substitutes; 2) The distribution of preferences for lpg’s and population should be considered in formulas for revenue sharing when subnational governments provide both lpg’s that are perfect and imperfect substitutes; 3) For local public goods that are imperfect substitutes, the share of tax revenue is first increasing and then decreasing with increases in the population of the district; 4) For perfect substitute-lpg’s, the share of tax revenue in the district is increasing and concave with the district’s population; 5) The distribution of income should not be considered in the design of formulas for lpg’s that are perfect and imperfect substitutes. Other empirically relevant comparative analyses are considered in the paper.