federal government decides on lump-sum transfers to local governments which, along with capi-
tal tax revenues, are spent on public consumption. The modeling choice mirrors the tax/transfer
assignment in a variety of federal states. The federal government makes unconditional trans-
fers to state governments, most notably to address a vertical imbalance of federal and state
tax revenues relative to their expenditure responsibilities or to undo horizontal imbalances in
local public funds. Although conditional grants to correct inefficient incentives to compete for
mobile capital are well understood in theory, their practical relevance is limited.3 As to the
allocation of tax instruments, in most countries the federal level has the income tax and the
value-added tax. In a static setting both taxes primarily resort to labor income as we assume
in the paper.4 Local governments in contrast have access to a limited set of tax instruments.
For instance, in Germany the only fiscally important local tax instrument is a source-based
capital tax (Gewerbesteuer) (levied by municipalities). Furthermore, it appears to be a common
feature of federations that states which are linked by a federal transfer system are engaged in
fiscal competition at the same time - e.g. Canada, Germany, USA.
We are interested in comparing the tax and expenditure choices when either the federal or
state governments are unable to pre-commit with the traditionally simultaneously determined
policy choices. Existing literature is open as to which pre-commitment capacity is more sugges-
tive in fiscal federalism. Based on institutional analysis5, Hoyt and Jensen (1996) argue that
U.S. states are able to pre-commit toward local governments. The ability reflects the consti-
tutionally anchored state government supremacy over local governments. In contrast, states
within the Russian federation are conjectured to be in a better position to pre-commit than the
3Indeed, the European Union addresses inefficiencies inherent to tax competition by tax coordination agree-
ments (involving e.g. information exchange among national fiscal authorities) rather than by implementing
Pigouvian grants.
4The common tax base also includes capital income which, as a source of tax revenue, is of minor importance
relative to labor income.
5Related econometric analysis is almost non-existent - the exception being Hayashi and Boadway (2001) who
report mixed evidence as to whether the federal government pre-commits towards provincial governments in
Canada.