each other with symmetrically chosen capital taxes. Straightforwardly, Vgi = b0(gi).
We consider a two-layer federal system: the federal level and the state level. State govern-
ments impose a source-based capital tax {ti}i=1,2. The tax revenues are recycled by providing
a local public good {gi}i=1,2 . The federal government provides transfers {si}i=1,2 which are
financed by a federally-uniform labor tax schedule τ.17 The state and federal budget constraints
thus are
gi = si + tiki and τ X li = X si . (6)
i=1,2 i=1,2
The federal transfer system features a gross equalization scheme (Boadway, 2004) in which
transfers have a dual role: they equalize public consumption across states and transfer federal
funds to lower-level governments in response to a vertical imbalance of tax revenues and expen-
ditures.18 Both levels of government are benevolent. State governments maximize the utility of
the representative household whereas the federal government chooses its policy instruments to
maximize the Benthamite welfare function ∑i =1 2 Vi(∙).
Pareto-efficiency requires
t1 = t2, τ = 0, and b0(gi) = 1. (7)
Uniform capital taxes ensure production efficiency and a zero labor tax rate leaves the labor-
leisure choice undistorted. Since capital is in fixed supply to the federation, a uniform capital
tax is non-distortionary from society’s perspective and revenues should only be raised through
capital taxation. The rate should be set so as to finance the efficient amount of local public
17Alternatively, {si}i=1,2 can be interpreted as public services which are federally provided and which are perfect
substitutes for the locally provided service. In the sequel we adhere to the “transfer view”. Transfers will more
likely be used for an interstate equalization of public funds and will thus exhibit the tax price effect characterized
in section 6.
18In contrast, a net equalization scheme only involves horizontal transfers (τ ≡ 0). Both types of equalization
schemes are of importance in real-world intergovernmental relations - even within one federation. For instance, in
Germany the municipal equalization system operates on a gross equalization basis while the equalization system
at the state level (Landerfinanzausgleich) is organized as a net equalization scheme.
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