Federal Tax-Transfer Policy and Intergovernmental Pre-Commitment

The underprovision equilibrium is related to the existence of a positive horizontal fiscal
externality. Capital leaves state i in response to a rise in its capital tax rate which, in turn,
raises the tax base in the neighboring state - a positive effect external to state i’s tax setting
behavior (Wildasin, 1989). In its absence (i^z ≡ θ) each state would provide the efficient amount
of public goods leaving no rationale for the federal government to fiscally accommodate lower-
level government finances (τ = 0).

5 Sequential Policy Choice: Pre-Commitment by the Federal
Government

In this section, we analyze whether the inefficiency of the public sector is attenuated when the
federal government has the capacity to pre-commit toward state governments (centralized lead-
ership). The sequence of decisions now becomes:

First Stage: The federal government chooses {sⁱ , τ}i=1,2 . It anticipates the reaction of the
state governments as well as the reaction of households and firms.

Second Stage: State i decides on its policy variable tⁱ taking the policy choice of the federal
government {sⁱ , τ}i=1,2 and the neighboring state government t^j as a given. It anticipates the
reaction of households and firms.

Third Stage: For given policy variables {sⁱ , tⁱ , τ }i=1,2 , households and firms choose {kⁱ , lⁱ }i=1,2 .

Again, the game is solved by backward induction in order to identify a symmetric subgame-
perfect equilibrium.

State Government The optimal policy choice of state i is tⁱ = tⁱ (sⁱ , τ). Inferring the slope
of the reaction function we differentiate the state first-order condition (9) and the state budget

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