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Vertical Versus Horizontal Tax Externalities: An Empirical Test
Journal of Public Economics
We study taxation externalities in federations of benevolent governments. Where different hierarchical government levels tax the same base, one can observe two types of externalities: a horizontal externality, working among governments of the same level and leading to tax rates that are too low compared to the social optimum; and a vertical externality, working between different levels of government and leading to suboptimally high tax rates. Building on the model of Keen and Kotsogiannis [Keen, Michael J., Kotsogiannis, Christos, 2002. Does federalism lead to excessively high taxes? American Economic Review 92 (1) 363?370], we derive a discriminating hypothesis to distinguish vertical and horizontal tax externalities based on measurable variables. This test is applied to a panel data set on local taxes in a sample of Swiss municipalities that feature direct-democratic fiscal decision making, so as to maximize the correspondence with the ?benevolent? governments of the theory. We find that vertical externalities dominate ? they are thus an observed empirical phenomenon as well as a notable extension to the theory of tax competition.
Tax competition, Horizontal externalities, Vertical externalities, Fiscal federalism, Swiss tax system
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