1 Introduction
In most countries decentralized governments have the authority to decide on local taxes and
expenditures. Independently of the degree of fiscal autonomy their policy choices are signifi-
cantly influenced by the fiscal relations with the federal government. Reflecting efficiency and
redistributive concerns the federal and local budgets are linked via a complex set of fiscal ar-
rangements which include equalization payments, matching grants, and revenue-sharing systems.
The way in which the federal tax-transfer system influences local policy depends on the spe-
cific formula used to allocate funds to local governments.1 However, the incentive effects of
the federal tax-transfer system are also related to the pre-commitment capacity by different
levels of government. As shown recently, efficiency in local fiscal choices can be realized without
resorting to formulaic (Pigouvian) transfers. Depending on the governments’ pre-commitment
capacity, lump-sum transfers may be sufficient to overcome inefficiencies which are rooted either
in a tax-base overlap or in public consumption spill-overs.2 The unorthodox efficiency results of
federal transfer policy have been derived in fiscal settings with either a perfect tax base over-
lap (Boadway and Keen, 1996) or exclusive taxation by lower-level governments (Caplan et al.,
2000). The paper deviates from these contributions (and from most existing analyses of federal
policy making) by assuming that the federal and local taxing authority does not perfectly over-
lap as e.g. observed in Canada, Germany and the U.S. We assume a two-layer federal system
with source-based capital taxation at the lower governmental level and labor taxation at the
upper level of government. Since capital is mobile between local jurisdictions, the capital tax is
distortionary from the perspective of local governments (Zodrow and Mieszkowski, 1986). The
1See Dahlby (1996) for an analysis of efficiency enhancing formulaic grants (Pigouvian grants). Equalizing
transfers may become formulaic by conditioning them on a measure of local fiscal capacity. Besides their redis-
tributive properties they are also capable of promoting efficiency - see e.g. Koethenbuerger (2002).
2Boadway and Keen (1996) show that if the federal government is able to pre-commit, lump-sum transfers are
sufficient to correct inefficiencies in local policy choices which relate to a tax base overlap. The efficiency result
extends to environments with decentralized redistribution (Boadway et al., 1998) and heterogeneous regions if
federal policy instruments are sufficiently differentiated (Sato, 2000). Reversely, if local governments are able to
pre-commit, federal lump-sum transfers induce local governments to efficiently contribute to a global public good
(Silva and Caplan, 1997 and Caplan et al., 2000).