Elsevier

Journal of Public Economics

Volume 90, Issue 3, February 2006, Pages 477-497
Journal of Public Economics

The incentive effect of fiscal equalization transfers on tax policy

https://doi.org/10.1016/j.jpubeco.2005.09.004Get rights and content

Abstract

A theoretical analysis considers the impact of a typical system of redistributive “fiscal equalization” transfers on the tax effort of local jurisdictions. More specifically, it shows that the marginal contribution rate, i.e. the rate at which an increase in the tax base reduces those transfers, might be positively associated with the local tax rate while the volume of grants received is likely to be inversely related to the tax rate. These predictions are tested in an empirical analysis of the tax policy of German municipalities. In order to identify the incentive effect the analysis exploits discontinuities in the rules of the fiscal equalization system as well as policy changes. The empirical results support the existence of an incentive effect, suggesting that the high marginal contribution rates induce the municipalities to set significantly higher business tax rates compared with a situation without fiscal equalization.

Introduction

Redistributive fiscal transfers between jurisdictions are a common feature of many federal countries with local taxing autonomy such as Canada, Germany, and Switzerland. Irrespective of whether explicitly labelled “fiscal equalization” or embedded in a system of revenue sharing, the common characteristic is that transfers are inversely related to the tax base or some corresponding measure of “fiscal capacity.” As a consequence, those schemes will tend to compensate jurisdictions for the adverse impact of a higher tax effort on the tax base. To put it differently, redistributive transfer schemes tend to lower the marginal cost of raising public funds and might, therefore, induce governments to raise even possibly distorting taxes (Smart, 1998, Dahlby, 2002). This incentive effect is not only important for the design of redistributive transfer systems but also for its effect on competition. Standard models of tax competition argue that in a decentralized setting the mobility of the tax base will tend to increase the marginal cost of raising public funds for each individual jurisdiction with adverse consequences for the supply of public services. Since redistributive fiscal transfers might have the opposite impact on the marginal cost of raising public funds, recent theoretical research suggests that a redistributive system of interjurisdictional transfers might help to restore efficiency in an otherwise inefficient equilibrium of tax competition (Bucovetsky and Smart, 2002, Koethenbuerger, 2002).

However, beyond theoretical considerations little is known about the significance and strength of incentive effects from fiscal equalization on the taxing policy of local jurisdictions. A paper by Baretti et al. (2002) deals with the case of German states. As these states lack taxing autonomy, the study focuses on the related issue of revenue collection and finds a significant adverse effect of fiscal equalization. Snoddon (2003) investigates the incentive effect of fiscal equalization in Canada. Facing complex interactions in the Canadian system of intergovernmental transfers, the empirical analysis focuses on policy reforms and finds support for incentive effects of fiscal equalization. However, the analysis is concerned with tax revenue, which is only an indirect measure of tax policy. The direct impact of fiscal equalization on tax policy is considered by Dahlby and Warren (2003) using a small dataset of eight Australian states and territories. They find some limited support for an incentive effect on taxing decisions.

This paper adds to the literature by providing an empirical investigation of the incentive effect of fiscal equalization on the local choice of the business tax rate in a dataset of German municipalities. There are several reasons why German municipalities offer a promising case to study. While these jurisdictions have tax autonomy in choosing the local rate of the business tax, a substantial amount of fiscal resources is redistributed among local governments. At the same time, tax autonomy is restricted to the choice of the tax rate since tax bases are defined uniformly across the country and tax collection is centralized at the state level. Even though empirical evidence is lacking, the potential incentive for higher tax rates is mentioned regularly in debates about the equalization system in Germany's state legislatures (e.g., Hardt and Schmidt, 1998: 160) and, occasionally, used even as a motivation for tax reform.1 Also previous research on the impact of local tax rates on revenue indicates potentially important incentive effects, as local tax rates are shown to exert quite strong tax base effects, indicating that the tax effort of German municipalities is unusually high (Buettner, 2003). A further advantage of the German case is the availability of corresponding data for a large panel of municipalities.

The following theoretical section discusses the choice of the local tax rate on capital in the presence of redistributive transfers. The model explicitly introduces a system of fiscal transfers such that taxing decisions are made conditional upon the rules determining the (net) contribution to the transfer system. The subsequent empirical investigation basically tests whether the predictions of the model are consistent with the data. The empirical analysis employs a panel dataset of municipalities in a major German state, Baden-Württemberg, over a period of 21 years. A special advantage of the dataset is that the system of fiscal equalization treats jurisdictions differently and differs across regions (counties) as well as across the time-period covered by the data; these differences allow us to pursue alternative identification strategies and to compare their results. The first approach taken in the paper exploits the fact that incentives are discontinuous functions of relative fiscal capacity which allows to employ regression discontinuity estimation techniques (e.g., Van der Klaauw, 2002, Angrist and Lavy, 1999). The second approach exploits the variation in incentives due to changes in the system over time. Regardless of the identification approach taken, the empirical results confirm the theoretical expectations. In particular, the marginal contribution rate is found to exert a significant positive impact on the local tax rate, whereas the volume of grants received has a negative effect on tax effort.

The paper proceeds as follows. The following theoretical section derives the basic predictions. Section 3, then, provides a discussion of the investigation approach including a stylized description of the equalization system. Section 4 gives an account of the dataset and is concerned with some specification issues. Section 5 reports the results. Section 6 provides a conclusion.

Section snippets

Theoretical considerations

Consider the tax policy of the local government of municipality i. Let the budget constraint of the government in per-capita terms bezi=τiki+gi,where zi is public spending, τi is the local tax rate on capital ki, and gi is inter-governmental revenue which may or may not be dependent on local policies. Assuming absentee capital-owners and assuming that labor supply corresponds to the size of the population, private consumption ci is determined by labor income obtained with a linear-homogenous

Investigation approach

The empirical investigation below aims at testing the predictions of the theoretical analysis using a panel dataset of municipalities in a German state. In order to analyze the incentive effect of fiscal equalization empirically, it is essential to specify the main determinants of the position and curvature of the budget set. As indicated by the above theoretical discussion, a key determinant of the curvature is the marginal contribution rate of the fiscal equalization system ϑi. It is also

Data and specification

The basic dataset consist of the complete set of municipalities in a major German state (Baden-Württemberg). However, many of these municipalities are rather small with population sizes below 10,000 inhabitants (see Appendix). Due to their smallness, these jurisdictions are subject to substantial fluctuations in taxing capacity.10

Results

Table 3 reports some basic results following the regression discontinuity approach. Aside from the key variables of interest, virtual grants and the marginal contribution rate, specifications (1) to (3) are controlling for relative fiscal capacity in various non-linear forms.15 In all specifications the sign of the effects is in

Summary and conclusion

Theoretical considerations suggest that fiscal equalization transfers exert an incentive effect on the tax effort of local jurisdictions. In particular, a higher marginal contribution rate is predicted to be associated with a higher tax rate and the level of a local government's virtual grant is predicted to exert a negative impact on tax effort.

These theoretical predictions about the incentive effect of fiscal equalization are tested using a large panel of German municipalities. The data allow

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    I would like to thank Helmut Cremer, Roger Gordon, Jim Poterba, Holger Sieg, participants in the NBER CESifo Trans-Atlantic Public Economic Seminar, and an anonymous referee for many very helpful comments and suggestions. However, the author is responsible for all errors. I am indebted to Sebastian Hauptmeier for his assistance in creating the institutional dataset. Support by the Deutsche Forschungsgemeinschaft within its Priority Programme 1142 “Institutionelle Gestaltung föderaler Systeme” is gratefully acknowledged.

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