Fiscal Competition among Regional Governments - Tax Competition, Expenditure Competition and Externalities -

Hikaru Ogawa

Public Policy Review, 2010, vol. 6, issue 1, 1-30

Abstract: This paper reviews a number of topics that have been analyzed in the field of fiscal competition. A representative fiscal competition analysis is found in the theory of capital tax competition, in which the regional governments compete for mobile capital, using capital tax/subsidy as a policy variable. However, making capital tax/subsidy a policy instrument is a merely a presumption that has been given exogenously. If it were more advantageous for governments to use other policy variables, such as the level of public infrastructure investment, competition would take the form of expenditure competition rather than tax competition. In the first half of this paper, fiscal competition studies on strategic choice of policy instruments are examined. We find here that policy instruments selected in equilibrium are, at least, influenced by the following two factors. Firstly, whether public spending contributes to the region as public goods that directly enhance the resident's welfare, or whether it works as public inputs that enhance regional productivity. Secondly, it may be influenced by the presence of benefit spillovers. The second half of this paper provides further details on the effects of the above two factors (public input vs. public good and spillovers) on the fiscal competition equilibrium. Specifically, a reexamination of the efficiency properties of public goods provision with spillover externalities is provided in the framework of fiscal competition. Traditional studies, analyzed in the absence of fiscal competition, suggest that the benefit spillover of local public goods is a source that distorts resource allocation. However, in the fiscal competition model, we identify another role of spillovers that works in the opposite direction, to argue that an increase in spillovers actually reduces the distortion due to externalities caused by fiscal competition, so that the existence of spillover might enhance full efficiency.

Date: 2010
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