Federal Tax-Transfer Policy and Intergovernmental Pre-Commitment



adjust. Note first that

>

(tcc)


.

1 + '   (tN N )


(15)


To verify the inequality note that the SMCPF is independent of τ since flk 0 and thus kτi 0.

Also, the SMCPF is higher the higher the level of symmetrically chosen capital taxes, because
kii (tc τc) = kii (tN τN) and hence tckii (tc τc) < tNkii (tN τN). Followingthefirst-Ordercondition
b0(дг) = i+i (Eq∙ (9)) the inequality (15) implies

b0(gi)(tcc) > b0(gi)(tNN)

By the strict concavity of b(gi), we can conclude that gi decreases relative to the Nash-level, i.e.

Public consumption becomes more downward distorted in the centralized leadership game.
A lower amount of labor-tax financed transfers exposes public consumption levels more to states’
incentives to compete for mobile capital - with the familiar consequence of a downward distortion
in public consumption.

In equilibrium, the total amount of tax revenues decreases, but taxes are more efficiently
collected. In spite of the efficiency trade-off, the welfare effect is ambiguous in sign. The federal
government is able to replicate the policy outcome under Nash-behavior by setting
τc = τN .
Consequently, revealed by the policy preference of the federal government (
τc < τN), welfare
improves relative to welfare under Nash behavior.

6 Sequential Policy Choice: Pre-Commitment by State Govern-
ments

In this section, states governments have the ability to pre-commit toward the federal government
(decentralized leadership). The sequence of decisions becomes:

16



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