Federal Tax-Transfer Policy and Intergovernmental Pre-Commitment

adjust. Note first that

To verify the inequality note that the SMCPF is independent of τ since f_lk ≡ 0 and thus k_τⁱ ≡ 0.

Also, the SMCPF is higher the higher the level of symmetrically chosen capital taxes, because
ki_i ∣(t_{c τc}) = ki_i ∣(_tN _τN) and hence tckii ∣(tc _τc) < tNkii ∣(tN _τN). Followingthefirst-Ordercondition
b0(д^г) = i+i (Eq∙ (9)) the inequality (15) implies

^b0(g^i)∣(tc,τc) ^> b0(g^i)∣(tN,τN)

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 τ^c = τ^N .
Consequently, revealed by the policy preference of the federal government (τ^c < τ^N), 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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