Abstract
Governments around the world implement policies aimed at developing certain geographic areas or regions within their respective countries. During the last few decades, local authorities have been assuming a predominant role in the design and execution of these policies. It has been argued that the decentralization of such responsibilities can potentially induce regional governments to behave strategically, initiating a fiscal competition game that would diminish the effectiveness of regional policies. This chapter critically reviews some of the most recent advancements in the literature, focusing on the work that examines the impact of fiscal competition on policy outcomes. At the same time, it intends to identify issues that require further study and provide guidance on the direction of future research in the area.
The views expressed are those of the author and do not necessarily represent official positions of the Federal Reserve Bank of Richmond, or of the Federal Reserve System.
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Notes
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Even though this chapter examines exclusively models of fiscal competition involving regional governments (also known as models of horizontal fiscal competition), it is important to acknowledge that a strand of the literature has focused on the outcomes arising from the strategic interaction between different levels of governments (vertical fiscal competition). In the latter case, strategic behavior may be triggered by the fact that the regional and federal governments levy taxes on the same tax base.
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See Ladd (1994) for a detailed classification of policies aimed at dealing with distressed areas.
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See Epple and Nechyba (2004) for a survey on fiscal decentralization.
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For example, it is generally believed that regional governments are limited in their capabilities of redistributing income because household mobility reduces the effectiveness of these policies. As a result, the federal government should undertake this responsibility.
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We will revisit the assumptions required for this conclusion to hold in Sect. 13.4.
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All policies should aim at improving the well-being of people. The difference between policies rests on the specific way in which they are structured to achieve the intend goal. To some extent, the discussion about which policy is better has been exaggerated. Empirical evidence is far from conclusive, suggesting that no policy clearly dominates another.
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The complete list of assumptions is the following: (i) consumers are perfectly mobile; (ii) there is full information; (iii) the number of communities is large; (iv) income is exogenous; (v) there are no spillovers across communities; (vi) the average cost curve for the provision of local public goods is U-shaped (i.e. there exists a cost minimizing population size); and (vii) communities with population sizes below (above) the cost minimizing size seek to expand (contract).
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The basic tax competition model, for example, focuses on the strategic determination of capital tax rates. Regional governments, however, compete on many other dimensions, so fiscal competition takes place through multiple channels.
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In the basic tax competition literature, the outcome is characterized by a lower than optimal spending on local public goods. The fact that the size of the local public sector becomes smaller under tax competition is not perceived as something necessarily bad by the public choice literature. This literature (see, for example, Brennan and Buchanan 1980) questions the assumption that governments are benevolent and choose the tax rates that maximize the welfare of their citizens. The primary objective of self-interested, rent-seeking governments, according to this view, is to maximize tax revenues and use those resources for unproductive purposes. So anything that would limit such behavior would be an improvement for the society.
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See, for example, Besley and Case (1995).
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Decisions by regional governments may generate other types of spillovers, such as direct geographic spillovers, which do not affect the relocation of mobile factors of production. For instance, consider spending on pollution abatement. When a region devotes more resources to reduce pollution, it creates a positive externality on neighboring jurisdictions. The latter does not include the case in which regions strategically choose regulatory policies to attract firms. Also, parks and other local amenities provided by one jurisdiction may be enjoyed and visited by residents from other locations. The decentralized solution in these two examples, as in the previous cases of fiscal competition, will also be sub-optimal, and a system of inter-regional transfers would be required to restore efficiency. This chapter will not focus on these external effects, however, since in principle they do not generate fiscal competition among regions.
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The model presented here follows closely Brueckner (2006).
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Note that in the case of R regions, z would simply represent an (R × 1) vector of policies.
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Assuming that the second-order condition for a maximum \(\partial ^{2}V ^{i}(\mathbf{z})/\partial (z^{i})^{2}\ \equiv \ V _{z^{i}z^{i}}^{i}(\mathbf{z}) < 0\) holds.
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It is generally assumed that decisions are made simultaneously. Among other things, this setup considers a situation in which no jurisdiction have the advantage of moving first.
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It should be noted that in general region i’s best response to z j may consist of a set of values of z i. This means that b i(z j) is actually a correspondence rather than a function. When not necessary, we will stay away from such technicalities and refer to b i(z j) simply as a function.
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While some papers derive the optimal allocations from the central planner’s problem and compares the optimal allocations to the decentralized solution, most of the literature simply compares the outcomes arising in the non-cooperative (decentralized) and cooperative (centralized) cases. In the latter case, it is assumed that governments have access to the same set of policy instruments.
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Note that this is different to the effect of policy z i on the marginal payoffs \(V _{z^{j}}\) defined earlier, or \(V _{z^{j}z^{i}}^{j}(\mathbf{z})\). Eaton (2004) classifies policies depending on their effects on the payoffs of the other region. Specifically, policies are called plain complements when the spillover effects are positive, and plain substitutes when they are negative.
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For example, Rota-Graziosi (2015) provides conditions to establish the plain and strategic complementarity of capital tax rates in the traditional tax competition.
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Another complication arises when households are also mobile, in which case it is necessary to keep track of where capital is employed and where households end up residing.
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The theory on supermodular games has been used until now simply to characterize the solution of the basic model of fiscal competition. However, to some extent, this theory has been underexploited in the literature. This theory is a lot more general, and can be applied to more complicated games in which regions have access to multiple policy instruments.
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For instance, the effects may compensate each other.
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Pinto (2007a) considers another model in which regional governments choose more than one policy instrument. Specifically, the paper studies the strategic determination of the structure of the corporate profit tax system when firms operate in multiple regions and regions use an apportionment formula to calculate the proportion of the firms’ income subject to regional taxation. The formula, as used in the USA, assigns weights to the proportion of the firm’s total sales, property, and payroll in a state. In the model, regions choose both the corporate income tax rate and the type of formula.
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It should be emphasized that the development of these techniques is far from uniform across different fields in economics. See, for example, Nevo and Whinston (2010) and Heckman and Vytlacil (2007) for general discussions on structural methods, and Epple and Nechyba (2004) or Holmes and Sieg (2015) for surveys on different applications of structural estimation to urban equilibrium and local public finance models.
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Some recent work has already taken such direction. For instance, Ossa (2015) uses a quantitative economic geography model to study the motives underlying the decision to subsidize the relocation of firms by regional governments.
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Pinto, S.M. (2017). Regional Policy and Fiscal Competition. In: Jackson, R., Schaeffer, P. (eds) Regional Research Frontiers - Vol. 1. Advances in Spatial Science. Springer, Cham. https://doi.org/10.1007/978-3-319-50547-3_13
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