existing literature - see e.g. Wildasin (1989).29 If state governments are however able to pre-
commit, a corrective grant will be neutral for state policy. Selecting fiscal instruments after state
taxes are chosen leaves no rationale for the federal government to implement corrective policies.
As states correctly anticipate federal policy incentives, the policy outcome of the augmented
decentralized leadership game (including corrective grants) will coincide with the one delineated
above.30
The paper’s results are of relevance for the design of tax coordination schemes which are
frequently recommended as a remedy to inefficient tax competition among EU member states.
If member states have the capacity to pre-commit, capital tax choices are inefficient similar to
the standard tax competition outcome. However, the rationale for tax coordination significantly
changes as it now also involves to redeem incentives to engage in transfer competition. Each
state’s incentive to deviate from the agreed tax rate (or interval) is guided by how the capital
tax base (as typically considered) and federal transfers react to a downward deviation in capital
taxes.31 It is left to future research how these considerations jointly affect the design of a tax
coordination agreement which is voluntarily respected by e.g. EU member states.
A Appendix
A.1 Slope of the Reaction Functions
In this part of the appendix we derive the slopes of the reaction functions si = si(ti, tj), sj =
sj(ti, tj), and τ = τ(ti, tj). Therefore, Eq. (11) (for both states) and the federal budget constraint
29We should note that introducing a federal corrective policy toward state governments would generically imply
an “undercorrection” of the tax competition externality since labor taxation is distortionary (e.g. Sandmo, 1975).
A first-best allocation would not be obtained.
30 Differently, if the federal government is able to commit to corrective policy, but in particular not to equalizing
transfers, corrective grants are effective in changing state taxing incentives. See Koethenbuerger (2007) for a
motivation of a partial commitment capacity by the federal government. Therein it is shown that not only the
type of the equilibrium externality changes (compared with the traditional normative prescription), but also the
way how the corrective grant needs to reflect the equilibrium externality.
31 See Huizinga and Nielsen (2003) for an analysis of self-enforcing tax coordination agreements if only incentives
to compete for mobile tax bases are to be redeemed.
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