federal government (Keen, 1998). Furthermore, among Canadian provinces Ontario is argued to
have the capacity to pre-commit since 40% of federal tax revenues stem from Ontario (Dahlby,
1996). In the European Union (EU) it is controversially debated whether Brussels has the abil-
ity to pre-commit toward member states. The “weakness” may reflect the bottom-up historical
evolution of European institutions which has left significant political power with member states
(Caplan et al., 2000).6
Also, federal governments are generically bound to equalize public funds across member
states so as to enable households access to a minimum public service level irrespective of the
place of residence in the federation (e.g. Boadway, 2004).7 The primacy often coerces federal
government to accommodate state governments’ finances ex-post; thereby undermining the fed-
eral pre-commitment ability.
The paper’s main results are as follows: If the federal government pre-commits towards local
governments, efficiency may not improve over all public decision margins. The federal govern-
ment optimally reduces transfers (and thus distortionary labor taxes) in order to strengthen
local incentives to resort to capital taxation. Thereby, it exposes public expenditure levels more
severely to the downward pressure exerted by fiscal competition. Despite the fact that the
efficiency effects of federal policy are countervailing, overall welfare increases.
If states can pre-commit, the welfare implications are ambiguous. The welfare differential
is non-monotonically related to the degree of capital mobility. With a high capital mobility,
6Two important political institutions in the EU are the European Commission (EC) and the European Council
of Ministers (consisting of member states’ ministers widely representing national interests). The EC has a decisive
role in legislature (e.g. EU budget legislation), but decisions taken by the EC generally need to find approval in the
Council of Ministers. At least to some extent, EU decision-making suggestively resembles negotiations between
member states which are pre-committed to national policies. The issue of policy commitment has received
attention in the discussion on the credibility of the Stability and Growth Pact which is intended to impose fiscal
discipline on member states’ public finances, see von Hagen and Eichengreen (1996). Some European member
states repeatedly violated the negotiated fiscal criteria possibly anticipating that the EC is not able to commit
to the enforcement procedure (prescribing fines). In fact, these states have been successful in abandoning the
enforcement procedure.
7The underlying principle of a “social citizenship” is constitutionally anchored e.g. in Canada and Germany.