Discussion Papers 2022

"Tax Competition and Efficient Fiscal Transfers under
Capital and Labor Income Taxes"

Matsumoto, Mutsumi and Hikaru Ogawa

June 2022

Title changed as "Corporate income tax competition and efficient tax base equalization"

Published in Economics of Governance 24(1) 109-118

This paper considers efficient fiscal transfer policies in a tax competition setting with ad
valorem taxation (i.e., income taxation) on mobile capital and immobile labor. We show that fiscal equalization of regions’ capital income tax bases eliminates the inefficiency of horizontal tax competition if these tax bases are evaluated by the average taxable return on capital in all regions, rather than the taxable return in each region. This equalization system, together with revenue matching grants that correct vertical externalities, achieves efficiency. By investigating the nature of horizontal and vertical externalities arising from non-cooperative regional tax policies, we derive formulas for efficient fiscal transfer policies and explain their workings.

Keywords: horizontal and vertical tax competition; horizontal and vertical externalities; ad valorem taxes; fiscal transfers.