VERTICAL INCOME TAX EXTERNALITIES AND FISCAL INTERDEPENDENCE: EVIDENCE FROM THE U.S. *

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1 VETICAL INCOME TAX EXTENALITIES AND ISCAL INTEDEPENDENCE: EVIDENCE OM THE U.S. * Álex Eseller-Moré a and Alber Solé-Ollé a Deparamen d Hisenda Pública Universia de Barcelona ABSTACT: Concurren axaion is a feaure of many federal sysems. As a consequence of his fac, he ax policy of one level of governmen affecs he ax base of he oher. This paper carries ou a heoreical analysis of he inerdependen ax-seing decisions of federal and regional governmens, paying special aenion o insiuional feaures ha characerise he U.S. federal sysem in pracice and ha formally link he axes employed a various levels of governmen (i.e.: ax deducibiliy). The developed hypoheses are esed wih daa corresponding o he U.S. personal income axes for he las decade. We find ha when he federal governmen increases axes, here is a significan posiive response of regional axes. JEL Classificaion Numbers: H3, H21, H77 Address: Alber Solé-Ollé ([email protected]) Dp. D'Hisenda Pública acula de Ciències Econòmiques Universia de Barcelona Av. Diagonal, 690, Torre 4, Pl. 2ª Barcelona (SPAIN) a We acknowledge financial research suppor as Consolidaed esearch Group in iscal ederalism and egional Economics, 97SG , by he Generalia de Caalunya, and also from CICYT SEC , Miniserio de Educación y Culura, and hank Loke Yiing Jia for providing par of he daa. We are graeful for he commens received from he paricipans in he esearch Seminar of he Universiy of Barcelona; he XXIII Symposium on Economic Analysis (UAB); he Vh Spanish Meeing of Public Economics (Universiy of Oviedo); he 1999 Annual Conference of he oyal Economic Sociey (Universiy of Noingham); he 4 h Spring Meeing of Young Economiss (Universiy of Amserdam); and he paricipans in he Workshop "iscal Compeiion and ederalism in Europe", in he ZEW. Especially helpful have been he commens from Anoni Casells.

2 NON-TECHNICAL SUMMAY The main aim of his piece of work is o check he empirical relevance of an economic failure ha can arise in a federaion. Technically, such problem is so-called "verical ax exernaliy". I produces when wo or more layers of governmen of he federaion share he same ax base. Under hose circumsances, and being such ax base disorionary (i.e., responds negaively o increases in he effecive ax rae), when one of hose layers of governmens increases he ax pressure over he ax base here originaes a decrease in he revenues of he oher layer of governmen as long as his does no change is ax parameers. However, i is expeced ha laer one (in our model, we suppose immediaely), he governmen ha had no varied is ax parameers do i now, in order he combinaion of fiscal pressure and public goods obained is opimal again. On he whole, he fiscal decisions of boh layers of governmen are no independen, and in he wors of he worlds, boh could end up in he negaive slope of he "Laffer curve", ha is, he co-ordinaion of heir ax decisions could incie governmens o se up ax levels so high ha would ge negaive variaion in revenues from ha ax rae increases. We empirically analyse he problem cied above wih US daa. The insiuional seing in ha counry perfecly fis he condiions required for a "verical ax exernaliy" o arise. On he one hand, he federal, Sae and local governmens share he income ax, which ax base is disorionary, as has been empirically showed in oher sudies. We cenre our analysis on he fiscal inerdependence beween he ederal and Sae governmen. And, on he oher hand, during he period of he sudy ( ) here have been quie imporan fiscal reforms ha allow for variabiliy in he effecive federal ax rae, o which according o our heoreical model should follow reacions in he Sae governmen's decisions. rom he resuls of he empirical analysis, we find ou ha cerainly here exiss a clear inerdependence in he fiscal ax decisions of boh layers of governmens. In paricular, we find ha when he federal governmen increases in one poin he effecive ax rae in he income ax, he Sae governmen do also increase heir ax rae, in 0.2 poins. However, such resuls canno be exclusively aribued o he effec of he "verical ax exernaliy", bu also o he effecs of he deducion of he Sae ax in he ederal ax (depending on he Saes, such deducion can adop several forms), hough from he empirical analysis, we canno discern he imporance of each one of hese effecs. 1

3 1. Inroducion Tradiional lieraure on fiscal federalism has devoed much ineres o he analysis of fiscal exernaliies ha arise among regional governmens. Many differen invesigaions have deal wih issues of ax compeiion, and ax exporing, boh heoreically (Gordon (1983), Arno and Grieson (1984) and Minz and Tulkens (1986)) and empirically (Sephenson and Hewe (1983), and Case (1993) on he firs opic, and Bird and Slack (1983) and Hogan and Shelon (1984) on he second one). There also exis some works analysing he relevance of expendiure spillovers among neighbouring regional governmens (Case, e al. (1993)). However - as Keen (1997) has poined ou in a recen survey -, i also has o be recognised he relevance of exernaliies beween levels of governmen. In a federal seing, characerised by he exisence of a federal governmen and many regional governmens, i is quie possible ha he policy decisions of one level of governmen have an effec on he policy oucomes of he oher level. If boh levels ignore such policy exernaliies, he resuling decenralised policy decisions could be sub-opimal from a social poin of view. Those verical spillovers can arise boh on he expendiure side of he budge (Dahlby and Wilson (1997)), and in ax-seing siuaions. This paper will deal wih his las opic. Verical exernaliies in he design of ax policy arise mainly as a resul of concurren axaion. In many federal counries, some ax bases are join propery of he federal and regional levels of governmen. Tha is, boh levels of governmen have he capaciy o change fundamenal ax parameers of he same base. I has o be sressed ha ax-sharing arrangemens ha is, when he regional governmen is eniled o receive a share of he revenues raised in is erriorial jurisdicion - do no conform o wha we mean by concurren axaion. Tax-sharing is a necessary bu no sufficien condiion for our definiion of concurren axaion; wha is in fac necessary is ha boh levels of governmen share ax powers regarding ha base. In ha case, he ax rae (or oher parameers of he ax ha define he ax burden) se by one level of governmen affecs he revenues raised by he oher. Of course, for ha verical ax spillover o arise he ax base has o be responsive o ax rae changes; ha is, he ax has o be disorionary. In his seing, if each level of governmen ignores he effecs is ax policies have on he revenues of he oher level of governmen, he ax raes will be raised oo much, and boh may obain less revenue 2

4 han in he case of co-ordinaed decision-making. The ineres of public finance scholars in ax spillovers arising from concurren axaion is very recen. Tradiionally, differen auhors have poined ou some adminisraive problems relaed o he join propery of ax bases. Musgrave (1983), and Break (1984) worried abou he higher compliance and adminisraive coss ha such a axing arrangemen among levels of governmen generaes, and Tanzi (1995) and Bordignon e al.(1996) emphasised he moral hazard problems appearing when differen levels of governmens collec join axes. Neverheless, he firs papers dealing wih verical exernaliies caused by uncoordinaed disorionary axaion where hose of lowers (1988) and Johnson (1988). More recenly, Wagoner (1995), Wrede (1995), Boadway and Keen (1996), Dalhby (1996), Boadway e al. (1997), and Sao (1997) have also addressed his issue. Up o now, and o our knowledge, he only aricle ha has ried o quanify he magniude of he ax inerdependence among levels of governmen is Besley and osen (1996). Their analysis deals wih spillovers in gasoline and cigarees ax seing, and uses U.S. daa for he period They find ha when he federal governmen increases is axes here is a significan response of sae axes, confirming he verical exernaliy hypohesis. However, we hink more empirical analysis of ha kind - exending i o oher federal counries and oher axes is needed. In paricular, i would be very ineresing o have beer knowledge abou verical exernaliies in firs class axes, like he personal income ax. The main purpose of his paper is precisely o perform an empirical es of he exisence of verical exernaliies in he U.S. personal income ax. In a forhcoming paper, we will analyse ha hypohesis for he Canadian case, paying special aenion o he ineracion beween he verical ax exernaliy and equalisaion grans. Inerdependen ax-seing decisions regarding o personal income axaion is acually a relevan field of sudy in he Spanish case. Nowadays, Spanish regional governmens have heir own progressive personal income ax. Alhough he definiion of he ax base can no be modified, he Spanish regional governmens have he power o change he ax raes and ax credis wihin some limis 1. Up o now, regional governmens have no used is ax power o modify ax burdens ye. 1 In paricular, he reform of he regional financing sysem in Spain has consised in spliing he personal 3

5 Neverheless, due o he shor life of his ax arrangemen, i is perhaps early o derive conclusions abou heir ax-seing behaviour. Moreover, he reform of personal income axaion currenly undergone by he cenral governmen will make more likely he reacion by regional governmens o he foresighed cenral income ax burden decreases 2. The srucure of he paper is as follows: in he nex secion, we presen a simple heoreical model in order o ascerain he sign and magniude of he responses of each level of governmen o ax rae changes of he oher. This model is developed in secions 2.2 and 2.3 according o he especial insiuional siuaions of he U.S. ha will be laer used in he empirical analysis. In secion 2.5, we perform some simulaions based on he heoreical model, and he real siuaions of he US. In he hird secion, we es he differen hypoheses we find in he heoreical model. inally, in he fourh secion, we propose some exensions o he analysis, and conclude wih some relevan commens for he Spanish case. 2. Theoreical Analysis In his par of he paper, our purpose will be he heoreical sudy of he verical ax exernaliy. In paricular, we wan o ascerain he sign and magniude of he reacion of each level of governmen o an exogenous ax rae change of he oher. In order o carry ou his analysis, we have o assume a cerain behavioural model of federal and regional ax- seing. However, here is no consensus among he public finance scholars wih respec o he mos appropriae way o represen he process ha generaes ax decisions. The mos commonly used is he median voer framework, bu oher poliically moivaed models, like probabilisic voing models (Dixi and income ax ino wo ariffs, 15% for he regional governmen, and 85% for he cenral governmen. A he same ime, he uncondiional gran hey previously received has been reduced by he same amoun as he sandardised revenues coming from he share of he personal income ax. Alhough, he regional governmens have now power o change he ax raes and he amoun of he ax credis, he variaion in he resuling regional ax liabiliy canno be higher han 20%. See uiz-huera, and López-Laborda (1997) for a criical revision of he reform. 2 The eform of he personal income ax has no sill been approved by he Parliamen. In any case, he purpose of reform consiss of a reducion of he op marginal ax rae from 56% o 48-50%, a generalised reducion in he ax burden of all income-classes, and a conversion of he personal ax credis ino a ax base deducion. Alhough any change in he ax base will affec boh he cenral and regional income axes, i seems ha he ax rae reducions will only apply o he cenral one. See Pedrós (1998) for a survey and commen of he planned reform. 4

6 Londregan (1998)), or raional rerospecive voing models (Besley and Case (1995,a)) could be used. Neverheless, as a pracical device, we employ a simple characerisaion of each governmen objecive funcion; accordingly, we will suppose ha each layer of governmen maximises he indirec uiliy of a represenaive agen. Given ha our ulimae aim will be he empirical esimaion of he regional response o changes in he federal ax rae in he US, we base he heoreical analysis on he paricular insiuional srucures of ha federal sysem. Apar from he verical ax exernaliy, in he U.S. here are paricular feaures ha link he income axes of boh levels of governmens. or insance, axpayers are able o deduc he sae personal income ax from he federal ax base (Tax deducibiliy). Moreover, in some saes hey can also deduc he federal income ax from he sae ax base (eciprocal Tax deducibiliy). As we will see, all hese special feaures will by hemselves lead o inerdependence in ax seing. Therefore, i will be necessary o isolae in he heoreical analysis he effec of hese insiuional feaures from he verical ax exernaliy iself The Basic Case We assume ha boh levels of governmen, he ederal and he egion 3, co-occupy he same ax base 4. They boh maximise he indirec uiliy funcion of a represenaive agen - which already embodies her maximising behaviour - subjec o heir respecive budge consrains, and aking as given he level of provision of he oher layer of governmen. This fac will precisely provoke he verical ax exernaliy we wan o sudy. Analyically, he problem for he regional governmen is he following 5 3 No wihou loss of generaliy, we assume ha here is jus one regional governmen. Oherwise, in conjuncion wih he verical ax exernaliy, we should also have o ake ino accoun he horizonal ax exernaliies. or a complee analysis of his las problem, see he classical work of Gordon (1983), while for a reamen of boh kind of exernaliies a he same ime, see Wrede (1996). 4 In our model, each layer of governmen jus has one ax insrumen. However, in a more general seing, here should be many axes a heir disposal. In ha case, here could appear cross-effecs due o he reacion of he bases o he ax raes of he oher insrumens. Noe ha in order a verical ax spillover o arise i would no longer be necessary he explici co-occupancy of ax bases. 5 In his basic seing, he problem of he ederal governmen can be analogously solved for. or ha reason, in his case, we jus presen he resuls for he regional governmen. 5

7 ( 1+ + ) + ( ) + ( ) Max V H G h g s.. B = g being he consumer price q = Is componens are he following:, he regional specific ax rae,, he federal ax rae, and he producer price ha has been normalised o he uniy 6. The res of componens are described as follows: B is he ax base; g is he regional public good; and G is he federal public good. The uiliy derived from regional and federal public good provision is represened by he funcions h(g) and H(G), respecively, which ener in an addiively and separable manner ino he indirec uiliy funcion 7 and behave in he usual way. We ransform he problem ino a direc one, once we have inroduced he regional budge consrain ino he objecive funcion. The firs order condiion (.O.C.) is he following, B q h g B B q : + + q = 0 (1) where we have made use of oy s Ideniy, V q = B, since we assume he marginal uiliy of privae income o be equal o one. We also suppose hroughou all he paper ha h( g ) is concave, i.e., h ε g 0 h ; he parial derivaive B q q B gg B 0, and so define he price elasiciy as q 0, which is supposed o be consan along he paper. Subsiuing his las definiion, and rearranging he equaion, we ge he radiional Samuelson condiion of public goods allocaion in he presence of disorionary axaion, 6 In fac, given ha he producer price is fixed and has been normalised o he uniy, ad valorem and specific ax raes are equivalen. Alhough his assumpion is no crucial for he base case, i will cerainly prove very useful when analysing he ax deducibiliy case. 7 This allows us o absrac from complemenariy and subsiuabiliy beween he ax base and public goods. In he same way, such reamen assumes independence beween he federal and regional public goods. This las assumpion is imporan in order o isolae he verical ax exernaliy effec from verical spillovers in public consumpion [Dahlby and Wilson (1997)]. 6

8 h g = 1 1 ε q MCP 1 (2) We define he righ hand side of he equaion as he regional marginal cos of public funds (MCP). This indicaes he marginal income loss for he represenaive ciizen for each addiional uni of revenue he governmen collecs. MCP is greaer han 1 (he marginal uiliy of income) as long as ε 0. This.O.C. has he same srucure for he federal governmen. When here is a marginal change in he federal ax rae, he regional governmen reacs in order o rebalance expression (2). We differeniae wo effecs ha work in he same direcion. The firs one is wha we call expendiure effec, and acs on he lef-hand side of expression (2). The ax base erosion due o he federal ax rae increase requires an increase in he regional ax rae in order mainain public revenues, and so he level of public good provision. This effec is reinforced by he fac ha we have assumed ha h( g ) is concave, and so increases in g are always posiively valued, hough decreasingly. The second one, which operaes on he denominaor of he righ hand side of expression (2), is he dead-weigh loss effec, and implies ha he region reacs also increasing is ax rae in order o keep he desired ad valorem ax rae. Analyically, all hese effecs express as follows, q hgg g MCP d + g d MCP + hg d + MCP 1 1 d = 0 (3) where he expendiure effec are he firs par of he expression, and he dead-weigh loss effec, he second one. earranging ha equaion, and subsiuing he parial derivaives, we can express he slope of he regional reacion funcion wih respec o he ax rae of he federal governmen 8, 8 rom now one, he sae and federal reacions will be expressed in his way, and so he relaed effecs will be implicily embodied in he slope of he reacion funcion. 7

9 d d = ε 1 q q B MCP B MCP h h gg h h ε + + q 2 2 g gg g ( 1 ) 0 (4) which is always posiive, since boh numeraor and denominaor are posiive 9. Expression (4) shows he inerdependency beween he ax raes of boh levels of governmens owed o he verical ax exernaliy. Noe ha if ε = 0, here would no be any reacion, d d = 0, since he ax base had no been affeced. In consequence, in our model, he exisence of he verical ax exernaliy crucially depends boh on he co-occupancy of he same ax base, and also on he disoring naure of he ax. Precisely, an empirical es of he verical ax exernaliy would consis in esing wheher such reacion is significanly differen from zero 10. The verical ax exernaliy comes ou because of an uncoordinaed ax seing behaviour by par of boh levels of governmen. In his decenralised seing, he decision of one level of governmen o increase/decrease is ax rae does no ake ino accoun he corresponden decrease/increase of he oher governmen s revenue. Being his he case, his siuaion leads o a level of axaion relaively higher in comparison o he level ha would be se by wo coordinaed governmens. To show such saemen, we find he opimal allocaion rule ha would be chosen by wo co-ordinaed layers of governmen. In order o do his, we maximise he same indirec uiliy funcion of he represenaive agen, subjec o he budge consrain of boh layers of governmen, and choosing simulaneously boh ax insrumens. 9 Noe ha alhough we have no developed he federal reacion funcion, by symmery can be checked ha also is slope will be posiive, d d The sign we have found crucially depends on he assumpion of consan elasiciy as Keen (1997) has properly noed. However, in order o es empirically he exisence of he verical ax exernaliy he imporan poin is no he sign of he reacion bu he reacion iself. 8

10 ( 1+ + ) + ( ) + ( ) Max V H G h g, s.. B = g B = G Deriving, we obain he.o.c. H G = h = g 1 1 = SMCP (5) ε ( ) q + ε 1 1 τ q We will call he righ hand side of expression (5) social marginal cos of public funds (SMCP). As can be easily checked, such expression will be higher han he MCP and MCP, since τ, he combined ax rae, will always be greaer han or. As a resul, he combined ax rae in he co-ordinaed case will be lower han in he uncoordinaed one. The opimal social level of axaion, τ *, is implicily defined by expression (5). Noe ha his value will no depend on he paricular srucure ha links he axes of boh levels of governmen (e.g., he presence of ax deducibiliy, a feaures ha will be analysed in he nex secions). Therefore, in order o deermine wheher he level of combined axaion arising from a paricular insiuional ax seing is excessively high, i will always have o be compared wih τ * The Case of Tax deducibiliy In he US, sae personal income axes are deducible when calculaing he federal income ax base. ecalling ha our ax raes can be considered ad valorem [vid. foonoe (6)], he expression of he consumer price redefines as q + + ( ) 1 1 λ, where λ is he percenage of sae ax deducible 11. Thus, we can see ha an increase in he sae ax rae ranslaes only in a ne increase of he ax burden 1 λ. Given he fac ha he ne sae ax burden is reduced by he inroducion of he deducibiliy, i can be expeced ha his ax provision creaes an incenive o a more inensive use of his source of revenue by he saes. Therefore, if he reacion of he sae o changes in he federal ax rae is posiive - as we have shown in he basic case [expression (4)] -, we would expec he inroducion of he ax deducibiliy o reinforce his reacion. 9

11 Taking ino accoun he new expression of he producer price, he problem of he Sae governmen now becomes ( 1+ + ( 1 λ )) + ( ) + ( ) Max V H G h g s.. B = g and, for he ederal governmen, ransforms ino ( ( 1 λ )) + ( ) + ( ) Max V H G h g s.. B = G ( 1 λ ) Therefore, in his case, he problem of boh layers of governmen is no longer symmeric. In paricular, wha has changed is he federal budge consrain, since now he ax deducibiliy provokes a revenue loss o he federal governmen. Now, we jus sae he.o.c. s, derived from each problem H G = ( λ ) = ε q 1 1 N ε q MCP (6) N and name ( ) 1 λ as he federal ne ax rae. or he sae governmen, h g = 1 1 λ 1 ε q MCP (7) Performing comparaive saic over expressions (6) and (7), we canno conclude wheher he ax equilibrium raes wih deducibiliy will be higher or lower han in he base model. In any case, we can inuiively see how boh he effecs of he verical ax exernaliy and he sae ax 11 Alhough λ = 1in he US case if he axpayer is an iemiser and 0 in oher case, ha parameer will be useful o derive comparaive saics properies. 10

12 deducibiliy poin ou in he same direcion, ha is, o an increase in he ax equilibrium ax raes. irs, concerning he regional governmen, here exiss wha we call a ax deducibiliy effec, which ends o decrease he MCP by he proporion 1 λ, and so o increase. Second, we deec a dead-weigh loss effec, which increases he MCP as increases, and so sops he increase in. Third, he expendiure effec makes increase, since h g is posiive. The sory would end up here if he federal governmen would no reac, and he regional equilibrium ax rae in his seing would undoubedly be greaer han in he base case. Oherwise, he conrareacion of he federal governmen weakens such relaed posiive effecs, and could even provoke he regional ax rae o be lower. This conra-reacion can be inferred from expression (6). Now he federal governmen experiences an expendiure effec, having an incenive o recover par of he revenues los wih he deducion increasing. However, as i raises he sauory ax rae i also increases he size of ha loss because of he increase in he deducibiliy rae. The federal governmen also experiences a dead-weigh loss effec ha increases is MCP and makes is ax rae decrease. Thus, he reacion of he federal governmen may no compleely resore he ne ax burden o he pre-deducibiliy level. If his happens, he dead-weigh loss effec for he regional governmen is in fac reduced, and so ends o lower he regional ax rae again making he final effec uncerain. Neverheless, we can show a paricular case where many hese effecs vanish. If ε = 0 - ha is, here is no verical ax exernaliy - MCP=1 and MCP = 1 λ. or he regional governmen, here is only a work he ax deducibiliy effec, while he behaviour of he federal governmen does only modify by an expendiure effec. Thus, on he one hand, he federal governmen is no affeced in he margin by he ax decisions of he regional governmen. In conras, he laer is cerainly affeced, and will see reduced is marginal cos, he greaer λ 12. In order o develop a es of he verical ax exernaliy, we mus firs develop he slope of he reacion funcions. or insance, for he regional governmen, oally differeniaing is.o.c., we 12 The empirical lieraure on he effec of he US federal ax deducibiliy of Sae axes implicily assumes ha he only effec a work is he ax deducibiliy effec. Several sudies [e.g., eldsein and Mecalf (1987), Lindsey (1988)] found a significan saisical effec of deducibiliy on he use of some sae axes. However, hey do no consider ha par of his effec may be due o he inerdependence caused by he verical ax exernaliy. 11

13 find i is 13 d d = ( 1 λ ) ε 1 q q B MCP B ( 1 λ ) gg ( 1 λ ) + ( 1+ ) MCP h h h h gg g q + ε 2 2 g λ 2 0 (8) rom i, and comparing wih expression (4), we can sae ha he reacion of he regional governmen will always be greaer han in he basic model. The reasoning is he following: on he one hand, in he numeraor, pushing up he regional ax response, here appears he ax deducibiliy effec, ( 1 λ ) λ. On he oher hand, in he numeraor, he firs erm is muliplied 2 by ( 1 λ ), while in he denominaor, he firs erm is muliplied by ( ) 1 λ. Being in pracise ha, his second effec does also push he sae reacion in he same direcion The Case of eciprocal Tax Deducibiliy In some US Saes, he sae income ax code also allows he deducibiliy of he federal income ax when calculaing he sae ax base 14. In order o analyse how reciprocal ax deducibiliy affecs he marginal cos his Saes face will follow eenberg and osen s (1986,a) 15 calculaion of he ne ax burden of boh levels of governmen wih reciprocal ax deducibiliy. I is obvious ha i is no possible o reciprocally deduc boh ax reurns acing sequenially. Therefore, we se up a simple sysem of equaions o calculae he ax price. We define ST and T as he sae and federal individual income ax burden, and λ as he percenage of deducibiliy, so we have ST = B λ T and T = B λ ST 13 All he analyical resuls derived from comparaive saic are available upon reques o he auhors. 14 According o he ACI (1995), eigh Saes allow heir axpayers o deduc he federal income ax from he regional ax base. These Saes are Alabama, Iowa, Louisiana, Missouri, Monana, Norh Dakoa, Oklahoma, Oregon, and Uah. 15 Vid. eenberg and osen (1986,a), page

14 Solving he sysem, we obain he ne ax rae for federal and sae governmen, ( 1 λ ) N = 2 1 λ and ( 1 λ ) N = 2 1 λ, and he combined ne ax rae, τ = ( 1 2λ ) +. 2 The numeraor in boh ne ax raes has he same srucure han in he case of he ax base deducibiliy. However, he denominaor picks up second round effecs, which are he same for boh governmens, which makes increase a lile bi more he nex ax raes 16. Thus, he reciprocal deducibiliy changes he ax raes in he way described above, and so he consumer price is now q = 1+ τ. Bearing his in mind, we can now solve he Sae problem, which soluion will be symmeric o he regional one. Analyically, 1 λ Max V 1+ s.. ( 1 2λ ) λ 2 ( 1 λ ) λ 2 B = g + H G + ( ) h( g) Operaing on i, we obain he.o.c. for he Sae governmen h g = 1 1 λ 1 ( 1 λ ) 1 λ 2 ε q = 1 1 λ 1 N ε q MCP (9) As we can see, expression (9) is characerised in he same way, as before, hough now here appears he sae ne ax rae. Given ha.o.c. (9) is exacly symmeric for he federal governmen, i is crucial o noe ha now also he federal governmen has an incenive o have a higher ax rae because of he ax deducibiliy effec. This new effec provokes second-round behavioural effecs for he sae governmen, reinforcing he endency o have higher ax raes in comparison wih he basic case. 16 As an example, le consider a federal and sae sauory ax rae of 40% and 20%, respecively. Then, if we allow sae ax deducibiliy agains he federal income ax base, he resuling federal ne ax rae is 0,4 x (1 0,2) = 0,32; while in he case of reciprocal ax deducibiliy, i is 0,32 / (1 0,4 x 0,2) 0,35, and he regional ne ax rae is now 0,2 / (1 0,4 x 0,2) 0,22. 13

15 In his case, he comparaive saic becomes very cumbersome, and i resuls very difficul o unambiguously sign he effecs provoked by he effecs we have found. However, in secion 2.4, we provide some simulaion resuls ha corroborae our guess ha boh ne ax equilibrium raes are higher han in he oher wo previous cases. I has also been very difficul o sign he slope of he sae governmen reacion funcion. Alhough, he higher federal ax raes in response o he possibiliy of ax deducibiliy reinforces he ax deducibiliy effec over sae ne ax raes, here exiss now anoher effec a work. rom expression (9), we can see ha increases in, hrough he erm 1 1 λ λ 2, will make he MCP o increase, leading o a higher reducion in han in he oher cases. In spie of he fac ha his effec may no be very pronounced, i could evenually dominae he posiive ax deducibiliy effec for high values boh of ne ax raes and ax base elasiciy 17 ; as a resul, in ha exreme case, he reacion of he ne ax raes could be negaive. Precisely, in he simulaions of secion 2.4, can be checked ha in he reacion funcions here is a peak a high level of ne ax raes 2.4 Simulaion resuls In order o ge a clearer picure of he consequences for ax inerdependence of he differen insiuional seings analysed in he previous secions we have carried ou some simulaions. Tha will help us o deermine he magniude of he equilibrium ax raes and he slope of he reacion funcions of each case. To perform he simulaions, we have made some assumpions. irs we have defined he ax base in he following way: B q ε. 18 Noe ha when here are no axes he ax base is normalised o one; ha means ha he simulaed ax base values afer he acion of he differen ax insrumens 17 Noe ha his erm, 1 λ 1 2 λ, muliplies ε q in expression (9), and he size of he erm increases boh wih and. 18 See Appendix 1 for a graphical exposiion of he Laffer curve arising from such a specificaion of he ax base. 14

16 have o undersood as percenage changes over he pre-ax base 19. Second we have defined he marginal uiliy derived from he federal and regional public goods as H G K = and h G g K =. g G and g are defined from he federal and regional budge consrains, which are differen in each case, and K and K are consan parameers ha have o be found in he calibraion procedure. Noe ha hese expressions are consisen wih he funcional form employed in our heoreical analysis. Subsiuing he expressions of B, H G, and h g ino he.o.c s derived for each of he cases previously analysed, we ge a sysem of wo non-linear equaions: K g K = MCP and = MCP (10) G This sysem is calibraed o find K and K wih he aim of be able o replicae he U.S. average federal and sae effecive income ax raes. We ake as he baseline case he Tax deducibiliy case, ha is really he siuaion in place in mos U.S. saes. In 1994, he average sae effecive income ax rae was 5,684%, and he average federal effecive ne income ax rae was 19,595% 20. rom each of he equaions in (13), and assuming ε = 0, 75, 21 we found K =0,178 and K =0,045. Taking hese values, we solve he non-linear sysem of equaions 22 o find and for differen siuaions ha we call: Verical ax exernaliy (ha is he basic case developed in secion 2.1), Tax credi 23, eciprocal ax deducibiliy (secion 2.3), and finally Lump-sum gran. 19 Alhough he ax base funcion we use for he simulaion does no derive from a specific consumer uiliy funcion, i is consisen wih he procedure employed in he heoreical analysis ha ook ha same approach. 20 Vid. for he saes, U.S. Bureau of he Census, Sae Governmen Tax Collecions by Sae, and for he federal governmen, U.S. Inernal evenue Service, Saisics of Income Bullein; boh for eenberg and eldsein (1995) quoe several U.S. sudies of ax incenives on labour supply, concluding ha he compensaed labour supply elasiciy is around he uniy. They also repor values for axable income elasiciy (ha addiionally include he effecs of ax rae on he form of compensaion, on deducible expendiures) beween 1,04 and 1,48. The value we have seleced is more conservaive han hose proposed by eldsein (1995,a), because we wan o show ha i is no necessary o employ very high ax base elasiciy values in order he verical ax exernaliy o arise. 22 To solve he sysem of non-linear equaions we have employed he lecher-powell algorihm. 23 Is analyical reamen is again available from he auhors upon reques. 15

17 To perform he simulaions for he Tax credi and he Lump-sum gran we have assumed ha hey cause a federal revenue loss equal o ha of he baseline case. The resuls of he simulaion for he U.S. case are presened in Table I. We presen he values of he MCP and MCP, sae, federal and combined ne ax raes, income ax revenues, and finally he share of sae income ax revenue over oal revenue raised from ha source. Also, in Appendix 2 we show graphically he reacion funcions and he equilibrium ax raes. As expeced, he sae ne ax rae is higher in he Tax credi and Tax deducibiliy cases han in he Verical ax exernaliy, and is even higher in he eciprocal ax deducibiliy case. On he oher hand, he federal ne ax rae is lower in he firs wo cases and higher in he Verical ax exernaliy. or each of he cases analysed we are able o calculae he slope of he regional reacion funcion by simple marginally perurbing he regional.o.c. a he Nash equilibrium ax rae. We show he resuls for wo differen values of he ax base elasiciy, 0,75 and 1,25. Our guess abou he relaive magniude of he reacion in he differen cases is confirmed. We can see ha effecively Table I: Simulaed equilibrium ax raes under differen regimes (USA) Verical ax exernaliy Tax credi Tax deducibiliy eciprocal ax deducibiliy Lump-sum Gran MCP MCP T T / T Noes: (1) MCP=regional marginal cos of public funds, MCP=federal marginal cos of public funds, =regional effecive ne ax rae, =federal effecive ne ax rae, T = combined regional plus federal effecive ne ax rae, =regional revenues, =federal revenues, T =combined regional plus federal revenues. he size of he reacion follows his paern: eciprocal ax deducibiliy, Tax deducibiliy, Tax 16

18 credi, Verical ax exernaliy and Lump-sum gran, and a hypoheical case wihou exernaliy (in which he response is zero). Those facs will allow us o develop in he nex secion some empirically esable hypoheses regarding he relevance of ax-seing inerdependence in he conex of he U.S. experiences. Table II: Simulaed responses of he regional ax rae o exogenous increases of he federal ax rae ε =0.75 ε =1.25 Verical ax exernaliy 0,10 0,14 Tax credi 0,19 0,25 Tax deducibiliy 0,26 0,37 eciprocal Tax deducibiliy 0,28 0,40 Noes: (1) These figures represen ne regional ax rae changes in response o an increase of he ne federal ax rae of 1 poin. (2) The slope of he reacion funcion is calculaed a he Nash equilibrium 3. Empirical implemenaion 3.1 Empirical framework Our main empirical purpose is o esimae he magniude of he reacion of regional income ax raes o exogenous changes in federal income ax raes; ha is, o esimae he slope of he reacion funcion of he regional governmen. We choose as our dependen variable he regional ax rae - and no he federal ax rae - because in pracice i is no rue ha here exiss only one regional governmen. Wih many regional governmens and having o define he same ax laws for he enire federaion, he federal governmen does no reac o he ax rae changes of each of he regional governmens, bu o a weighed sum of all of hem. 17

19 We use he effecive average ax rae as he definiion of our ax variables (we label and as he ne effecive average regional and federal income ax raes). Those ax raes are calculaed as he raio of income ax revenue o personal income. Tha is he so-called fiscal pressure 24. We have chosen personal income insead of axable income or a more narrow and legal definiion of he ax base o avoid he effecs ha changes in he definiion of he ax base over ime and regions have on he ax burden. This procedure is suppored by he way income ax reducions are usually carried ou; alhough in many cases he changes in effecive ax raes have followed sauory ax changes or changes in deducions and credis, in many ohers income ax reforms have changed also he definiion of ax bases. Therefore, doing he calculaion in ha way means ha we do no accep as accurae, reliable and sable he definiion of ax base given by he U.S. federal governmen or by sae governmens. The analysis is carried ou for U.S. wih daa corresponding o he las decade. The comparaive saics resuls derived in secion 2 for he specific insiuional feaures of hose counries allow us o develop complemenary hypohesis o es. In he U.S. seing we expec he reacion o exogenous federal ax rae increases of he saes ha allow he deducibiliy of he federal income ax o be higher han he saes ha do no have ha provision in heir ax code. In he Canadian case, we expec he reacion of he provincial governmens wih a lower/higher ax rae han he benchmark average ax rae used for equalisaion purposes o be negaive/posiive. Addiionally, we expec he reacion of he provincial governmens ha do no receive equalisaion funds o be posiive and higher han ha of he provincial governmens ha receive equalisaion funds and do have a ax rae higher han he average. 24 Alhough his variable is no he bes alernaive o accoun for he impac of axaion on he allocaion of resources in an economy, i is he bes pracical soluion we have been able o find. Of course effecive average marginal ax raes (Seaer (1985)) would seem o be a more ineresing variable o sudy, bu he problem is ha hey are no found in usual saisical sources. Some auhors have also argued in favour of he use of marginal ax raes compued direcly from he sauory ax funcion (Barro and Sahasakul (1986)), or o use he op marginal ax rae (Tannenwald (1991), and Mullen and Williams (1993)). However, his las approach seems beer suied o analyse problems of horizonal fiscal compeiion. Since he mobiliy of business and high income axpayers is affeced only by sauory ax differenials, he measure of fiscal compeiiveness of he regional governmen does no have o be affeced by is income disribuion or he composiion of he ax base - as are effecive ax raes. Neverheless, as we are mainly ineresed in verical spillovers, we can no employ simple characerisaions of he sauory regional ax funcion. 18

20 Verical spillovers are jus one of he facors ha influence ax-seing. Tax decisions are carried ou wihin a very complex insiuional process ha accouns for he preferences of voers, elecoral ineress of poliicians, and economic, insiuional and culural consrains. Many of hose influences are correlaed wih federal effecive ax raes, hwaring any direc inference abou is effecs on regional ax raes. As a resul of his, and in order o isolae he effec of ax inerdependence, i is necessary o conrol for all he oher relevan variables ha affec he regional ax-seing process. We include several groups of conrol variables: Economic resources. icher populaions will demand more regional public goods and, as a consequence, will olerae higher income axes; we include personal income per capia (Inc), and personal income per capia squared (Inc 2 ) o conrol for his effec. Alhough richer governmens - ha is, governmens receiving more grans from he federal governmen - will also spend more, hey will reurn par of he amoun received o is ciizens; so we expec ha income axes will be lower, he higher he amoun of ransfers received. To conrol for his effec, we include he per capia amoun of grans received from he federal governmen (Gran). Expendiure needs. Populaions wih higher shares of poenial users of public services and/or higher cos of delivering hose services will need higher levels of expendiure and, herefore, will be burdened more heavily hrough income axes. We include as explanaory variables he size of wo groups of poenial inensive service users: he proporion of populaion over 65 and under 18 (Pop(>65) and Pop(<18)); we also inroduce as cos variables he size of he populaion (Pop), is squared (Pop 2 ), and he densiy of populaion (Den). Poliical environmen. Alhough many poliically moivaed models of public policy generaion sugges ha paries converge a he same plaforms regardless of is ideology 25, many ohers suggess ha if poliicians are policy-moivaed and do no only care abou winning elecions he policies implemened need no be he same. or insance, in he U.S. case, some scholars have suggesed ha Democra governors en 25 See Alesina and osenhal (1995), chaper 2, for a survey. 19

21 o ax and spend more han heir republican counerpars (Besley and Case (1995,b) 26 ). We include a dummy variable ha accouns for he ideology of he regional execuive (D-ExecD, i akes he value of one if he execuive is relaively on he lef wing of he poliical arena), and oher wo variables ha accoun for he ideology of he upper and lower regional legislaive chambers (UpperD and LowerD, which are he proporion of lef wing represenaives in each chamber). 3.2 The U.S. case: model specificaion and resuls We will use a panel of daa corresponding o he period o es he ax inerdependence hypohesis for he U.S. case. This period is of special ineres because i includes a period of reducions in federal effecive ax raes ( ) as a resul of he Tax eform Ac of 1986 (Gouveia and Srauss (1996)) and a period of ax increases in he following years. Many scholars have wrien abou he effecs of TA86 on Sae governmen (e.g.,gold (1991), Ladd (1993) and Tannenwald (1991)). However, mos of heir aenion has been devoed o he analysis of he impac of he reform on Sae revenues, derived from formal links beween federal and sae income axes. Alhough in many saes he sae income ax srucure does no conform a all wih he federal definiion, in many ohers he ax base employed is he federal Adjused Gross Income (AGI), or even he federal Taxable Income (TI - ha is, AGI less sandard or iemised deducions). Moreover, in some saes he income ax is calculaed as a surcharge over he federal ax liabiliy (TL) 27. Tha means ha federal ax reform will affec in a differen way hose groups of saes, also depending on he way ha changes have produced. On he one hand, 26 Alhough here is also empirical evidence ha raising axes has high poliical coss (in erms of voes los) regardless of he ideology of he pary in governmen. See Pelzman (1992) for evidence regarding he saes in U.S., and Suar and Landon (1997) for evidence regarding he Canadian provincial governmens. 27 In he US, here are seven Saes ha do no make use of heir power o ax individual income. rom ACI (1995), we know hese saes are Alaska, lorida, Nevada, Souh Dakoa, Texas, Washingon, and Wyoming. New Hampshire and Tennessee jus make a limied use of i, since only cerain ineres and dividends are axed. On he oher hand, here were five saes which ax did no conform a all wih he federal one (New Jersey, Pennsylvania, Alabama, Arkansas, and Mississippi), eigh of hem use a definiion of ax base equal o he federal Taxable Income, hree impose a ax surcharge on he federal Tax Liabiliy, while he res of hem use he AGI as ax base. 20

22 for he group of saes ha do no conform a all heir income ax wih he federal one, here is no any direc impac on revenues colleced. On he oher hand, for he saes ha use a ax surcharge, all he changes in he federal effecive ax raes (coming from changes in he definiion of he ax base, changes in deducions and ax credis, and changes in sauory ax raes) will affec heir revenues. The saes ha use he federal AGI as ax base will be affeced only by changes in he definiion of Gross income and in he cos of earning income, while for he saes ha use he TI, heir colleced revenues will be influenced by changes in federal deducions. Neverheless, he wind-fall gains (or losses) arising from his kind of direc effecs we have relaed above mus no have any influence on he opimal ax raes derived from our heoreical ax model. This is due o he fac ha a governmen ha maximises he uiliy funcion of he represenaive ciizen would reac o he changes passed by he federal governmen adoping he necessary legal acions o keep effecive ax raes a he opimum. If we checked in he empirical model ha he saes jus ake as given he wind-fall gains or losses wihou any addiional legal ax change, ha would sugges he exisence of some sor of fiscal illusion. However, in some cases i would be difficul o disenangle he passive adjusmen from he acive reacion due o he verical ax exernaliy and o ax deducibiliy. Tha would happen if boh reacions go in he same direcion 28. The only way o es if he reacion is due o economic behaviour or o fiscal illusion is o allow he coefficien of o differ among he four groups of saes previously defined. If we check ha he reacion is similar for all of hem we could conclude ha he cause is owed o he verical ax exernaliy, and no o fiscal illusion. The basic equaion employed o es all hese hypohesis is he following:,i = α 1 (Dec i x,i ) + α 2 (DNec i x,i ) + α 3 (DNC i x,i ) + α 4 (DAGI i x,i ) + α 5 (DTI i x,i ) + α 6 (DTL i x,i ) 28 or insance, suppose ha he federal effecive ax rae increases because of a widening of he AGI; a regional governmen whose ax base is he AGI will see increase also is effecive ax rae. If ha sae governmen suffers from fiscal illusion, i would no reac and he sae effecive ax rae would increase. Bu even if he sae does no suffer from fiscal illusion, according o our heoreical predicions, i will no have o pass legal ax changes o mainain he opimaliy of is effecive ax rae (remember ha he combined effec of he verical ax exernaliy and ax deducibiliy imply a higher desired effecive ax rae). 21

23 + α 7 L,i + α 8 (, i x ( 1, i )) + k α k Z k,i + α 0,i + α 0, + ε i (11) Where Dec is a dummy variable equal o one if he sae ax code allows he deducibiliy of federal income ax, DNec is a dummy equal o one is he federal income ax is no deducible from he sae ax, DNC is a dummy equal o one if he sae ax does no conform a all wih he federal ax definiion, DAGI is a dummy equal o one if he sae base is he AGI, DTI is a dummy equal o one if he sae base is he TI, DTL is a dummy equal o one if he sae uses a ax surcharge on TL, Z k,i are he conrol variables defined in he previous secion. L,i is a variable ha reflecs he degree of uilisaion of he income ax by local governmens of he sae, and is purpose is o es also wheher he ax exernaliy is reinforced in hose saes where he income ax is join propery of he hree layers of governmen. We expec ha he reacion of he sae ax rae o increases in he local ax rae will be also posiive. The variable (, i x (1 -, i )) picks up he effec of horizonal ax compeiion on he level of sae ax raes;, i and, i are he effecive average sae and federal ax raes of he whole U.S. The firs par aemps o reflec he gross ax differenials among he saes 29, and he second accouns for he fac ha he ax deducibiliy offses par of hese gross differenials; ha is, ne ax differenials decrease when federal ax raes increase (and hen reduce he incenives o move among saes) 30. The subscrip i indicaes he sae, indicaes year and k idenifies he conrol variables. The coefficiens α 0,i and α 0, represen, respecively, sae and ime specific effecs. The esimaion of a fixed effecs model by OLSQ will give us consisen esimaes of he parameers whenever he sae effecs are correlaed wih he explanaory variables included in he equaion (Mundlak(1978)). Sae fixed effecs represen specific circumsances of each sae ha say relaively consan during he analysed period: characerisic of he local poliical marke, specific differences in he cos of local public or a permanen inflow of revenue from oher ax resources. Oherwise, if hese were 29 This is only a raw approximaion o measure he ax levels of each sae poenial compeiors (see Tannenwald(1991) for a previous use of ha measure). To correcly accoun for ax compeiion we would have o specify more accuraely which saes are fiscal alernaives for each oher. 30 The definiions of all he variables and he saisical sources are presened in Table III. The main descripive saisics are presened in Table IV. 22

24 correlaed wih he variables included in he empirical model, he obained parameers would be inconsisen (Holz-Eakin(1986)). The model is esed using daa for he 41 saes ha have broad-based income ax during he period ; ha he number of observaions is 410 (41 x 10). We have esimaed boh a fixed and a random effecs version of he model. However, for he differen specificaions we have ried, he hypohesis of correlaion of he fixed effec wih he variables included in he model has been acceped a 99% confidence level (ha is, he Hausman es is overcome, refusing he uilisaion of a random coefficien model). or his reason, we only repor he resul for he fixed effecs model. We have also performed he Breusch-Pagan es o check he presence of heeroscedasiciy rejecing his possibiliy in all he cases. The resuls of he esimaion are displayed in Table V. We presen four differen economeric specificaions. In model 1 we employ do no allow he coefficien of he variable o vary by groups of saes and we do no include any oher variable bu he conrol ones. In model 2 we include also he local ax rae, he ineracion beween and he dummy of eciprocal ax deducibiliy, and he horizonal compeiion variable. In model 3 we include he same variables of model 2 bu esimae differen slopes for he differen groups of saes. inally in model 4, we inroduce he ineracion variables beween he poliical environmen conrol variables and. rom he resuls of he esimaion we can confirm some of he hypohesis developed up o now. irs, and mos imporan, he sign of he sae reacion o federal ax changes is posiive and saisically significan (see models 1 and 2). A 1% poin change in he federal effecive ne ax rae supposes a variaion in he sae ax rae beween 0,20 and 0,25% poins. Tha high value could include he effecs boh of he verical ax exernaliy and of he ax deducibiliy, bu we are no able o isolae one from each oher. Noe also ha he parameer remains sable when esimaed separaely for each group of saes (model 3); ha is, he reacion of a sae which income ax is no formally linked wih he federal ax is exacly he same ha he reacion of a sae ha uses federal definiions a some sage of he calculaion of he ax liabiliy. Therefore, we can refuse he fiscal illusion hypohesis. 23

25 Second, he parameer of ineracion of he federal ax rae and he dummy for reciprocal ax deducibiliy is posiive bu no saisically significan a convenional confidence inerval. The size of he coefficien is no very high; bu remember ha he predicion of he heoreical model was ha he reacion would be in ha case jus slighly higher. Third, and very imporan as well, he parameer of he local income ax level variable is also posiive, saisically significan, and of a considerable magniude (models 2, 3 and 4). A 1% poin change in he local ax rae supposes a variaion in he sae effecive ax rae around 0,25% poins. Tha is, he sae effecive income ax reacs similarly o increases of oher axes ha burden is base, regardless of he level of governmen ha levies hem. However, also in his case his parameer embodies boh he effec of he verical ax exernaliy and he effec of he deducibiliy of local axes ino he sae income ax. ourh, ne sae ax differenials seem o have a pronounced impac on sae ax-seing decisions (models 2, 3 and 4). Tha is, a decrease in he ne effecive ax rae (afer he federal offse) of he whole U.S. of 1% poin would make sae ax raes decrease by 0,3% poins. This resuls does no necessarily ell us ha ax bases fly among saes in response o ne ax differenials, bu cerainly ells us ha ax officials hink he erosion of ax bases (or in voes) will be high if hey do no mimic wha everybody else is doing. ifh, here is some inconclusive evidence on he possibiliy of a differen reacion depending on he ideology of he pary ha conrols he poliical insiuions of he saes. Noe from he resuls of model 4 ha he coefficien of has decreased bu ha he coefficien of he variable ha ineracs wih a democra governor or a lower house conrolled by democras is posiive and significan (alhough he second one only a a 90% confidence level). On he oher hand, he effec of an upper house conrolled by democras has a posiive bu no saisically significan effec on sae ax reacions o federal ax changes. In any case, he effec is of a reduced magniude, and we can conclude ha democras and republicans reac o federal ax changes roughly in he same way. inally, we should noe ha he resuls obained for he conrol variables are generally as 24

26 expeced. icher populaions demand more public goods, and so ax income more heavily (Inc and Inc 2 are saisically significan in model 4); richer governmens reurn a highes amoun of he ransfers received o is ciizens (he sign of Gran is negaive bu no significan). The size of he populaion resuls no significan in any of he models, bu he densiy of populaion seems o impac negaively on income ax collecion, showing perhaps higher cos due o he dispersion of he populaion, or higher possibiliies o ax oher bases in urban seings (e.g.: sales axaion). The saes wih a high proporion of populaion over 65, and o a lesser exen, wih a high proporion of populaion under 18, use more inensively he income ax, maybe due o he higher demand of hose wo groups. inally, wih respec o he dummy variables ha characerise he poliical environmen of he sae, only he proporion of senaors ha are democra is significan, hough he sign is negaive in his case. 25

27 Table III: Definiion of he variables and saisical sources Variable Definiion Saisical sources L Dec Sae effecive average ax rae as a percenage of personal income ederal effecive average ax rae as a percenage of personal income =0.05 if some local governmens are eniled o use he income ax base and 0.2 if he nominal local ax raes are high =1 if he sae personal income ax allows for he deducibiliy of federal income axes U.S. Bureau of he Census, Sae Governmen Tax Collecions by Sae U.S. Inernal evenue Service, Saisics of Income Bullein, quarerly A.C.I.. Significan eaures of iscal ederalism, Vol. 1. A.C.I.. Significan eaures of iscal ederalism, Vol. 1. Inc Personal income per capia in 1986 Dollars Bureau of Economic Analysis, egional Accouns Daa Gran ederal grans per capia in 1986 Dollars U.S. Bureau of he Census, ederal Expendiures by Sae for iscal Year, annual Pop Sae populaion U.S. Bureau of he Census, Curren Populaion epors Den Sae populaion per square Km U.S. Bureau of he Census, Curren Populaion epors Pop(>65) Proporion of populaion over 65 Pop(<18) Proporion of populaion under 18 DNC =1 if he sae base does no conform wih any federal definiion U.S. Bureau of he Census, Curren Populaion epors U.S. Bureau of he Census, Curren Populaion epors A.C.I.. Significan eaures of iscal ederalism, Vol. 1. DAGI =1 if he sae base is he federal AGI A.C.I.. Significan eaures of iscal ederalism, Vol. 1. DTI =1 if he sae base is he federal TI A.C.I.. Significan eaures of iscal ederalism, Vol. 1. DTL = 1 if he sae applies a ax surcharge over he federal ax liabiliy A.C.I.. Significan eaures of iscal ederalism, Vol. 1. D-ExecD =1 if he sae governor is a Democra Congressional Quaerly Inc., America Voes, biennial UpperD Proporion of he sae house represenives ha are Democras The Council of Sae Governmens, Sae Elecive Officials and he Legislaures, LowerD Proporion of he sae senaors ha are Democras biennal The Council of Sae Governmens, Sae Elecive Officials and he Legislaures, biennal 26

28 Table IV: Summary saisics( ) Variable Mean Sandard deviaion Minimum Maximum 2,302 0,754 0,009 4,159 9,464 0,935 7,608 13,661 Drec 0,231 0,422 0,000 1,000 Inc , , , ,024 Gran 665, , , ,305 Pop Den 68,649 88,488 2, ,591 Pop(>65) 12,705 1,547 8,210 15,954 Pop(<18) 26,384 2,276 22,610 38,178 D-ExecD 0,512 0,500 0,000 1,000 UpperD 73,391 75,065 43,478 97,059 LowerD 62,081 69,872 44,843 92,619 27

29 Table V: Esimaion resuls, dependen variable, Nº Obs.= 410 (N = 41, T=10) ; ixed effecs esimaion Variable Model 1 Model 2 Model 3 Model (12.745) *** (16.790) *** (14.102) *** x DNC (10.415) *** x DAGI (21.055) *** x DTI (12.484) *** x DTL (8.870) *** L (2.265) ** (2.451) *** (2.072) ** x Drec (0.349) (0.603) (1.232) x(1- ) (6.087) *** (6.245) *** (7.156) *** x DexecD (1.987) ** x UpperD (0.686) x LowerD (1.738) * Inc (x 10-3 ) (-1.214) (-1.394) (-1.475) (-2.023) ** Inc 2 (x 10-3 ) (1.541) (1.603) (1.724) * (2.652) *** Gran (x 10-3 ) (-1.014) (-1.284) (-1.452) (-1.577) Pop (x 10-5 ) (-1.218) (-1.223) (-1.155) (-1.409) Pop 2 (x ) (1.247) (1.341) (1.329) (1.397) Den (2.141) ** (2.038) ** (2.122) ** (-2.272) ** Pop(>65) (2.221) ** (2.037) ** (2.051) ** (2.274) ** Pop(<18) (1.741) * (1.889) * (1.902) * (1.871) * DexecD (0.048) (0.186) (0.338) (0.695) UpperD (-0.101) (-0.133) (-0.117) (0.587) LowerD (-1.974) ** (-2.048) ** (-1.079) (-2.118) ** B.P D.W (C vs. C i ) *** *** *** *** χ 2 (Hausman es) *** *** *** *** 28

30 4. Conclusions In his paper, our main aim was o es empirically he relevance of he verical ax exernaliy for personal income axaion. The evidence we have found seems o confirm ha hypohesis. The heoreical model developed in secion 2 prediced a posiive reacion of each level of governmen o changes in he effecive ax raes of he oher. The model also found ha in he presence of Tax deducibiliy and eciprocal ax deducibiliy he reacion were more pronounced. The simulaions performed in secion 2.4, calibraed o reflec he curren U.S. siuaion, have allowed us o have a guess abou he magniude of he response in he differen cases. inally, he resuls of he empirical analysis of secion 3 have permied us o confirm such resuls. We have found in our economeric analysis ha one poin increase in he federal ne effecive ax rae is followed by an increase of approximaely 0,25 poins in he sae ax rae, a response very similar o he reacion found previously in he simulaions (for a ax base elasiciy of 0,75). We hink his magniude is consisen he effecs of he verical ax exernaliy and he ax deducibiliy working simulaneously. emember ha he magniude of he reacion obained in he simulaions for he Verical ax exernaliy case was around 0,10 poins (for he same value of he elasiciy). We have compued ha if here were no verical ax exernaliy bu only he ax deducibiliy, he simulaed reacion would be of 0,09 poins. However, o obain a definiive conclusion of he relaive imporance of boh effecs we would have o compare a real siuaion wihou ax deducibiliy wih he resuls of he U.S. case. A he momen, we are developing an empirical es for he Canadian case ha would allow us o perform his comparison, and so o improve our presen conclusions. If our guesses abou he empirical relevance of he verical ax exernaliy are rue, useful poliical economy insighs for he Spanish case can be derived. As commened in he inroducion, he Spanish regions have recenly achieved a relaively imporan power on he personal income ax. The criics of his reform have only emphasised he negaive effecs of poenial ax compeiion among regions. However, as we have shown, he verical ax exernaliy can provoke disorions on ax decisions ha could be equally harmful. In any case, he poenially negaive effecs of he verical ax exernaliies should be balanced wih he posiive effec of greaer fiscal responsibiliy a he regional level of governmen. 29

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