How to stop the race to the bottom

Abstract

Standard tax multipliers are a widespread feature of fiscal equalization systems. A simple theoretical model shows that actual tax multipliers respond positively to changes in standard tax multipliers. This theoretical prediction is tested empirically using data on municipalities in Germany. A quasi-experiment in the state of North Rhine-Westphalia is exploited to identify the incentive effect. The empirical results confirm that local business tax policy is shaped by standard tax multipliers. They provide a straightforward practical tool to avoid a race to the bottom in local business tax rates.

Fiscal equalization and the tax structure

“…For the local business tax, by contrast, neither the specification in levels nor in firstdifferences features significant pre-reform 'placebo' effects (columns 3 and 4), thus confirming the visual pattern emerging from Figure 5 (see also Rauch and Hummel (2016) in support of this conclusion); the coefficients on the reform-year interaction terms are less precisely estimated for the tax rates in first differences, however, turning significant only in one of the reform years, 1997, and only at a 10% level.…”

“…For further discussion, seeFarhi and Werning (2017).5 For theoretical treatments, seeWildasin (1989),Dahlby and Wilson (1994),Smart (1998), andKöthenbürger (2002). For empirical evidence, see for instanceBüttner (2006), Egger et al (2010,Baskaran (2014) andRauch and Hummel (2016) in the context of German municipal finance, as well asDahlby and Warren (2003) andSmart (2007) for the Australian and the Canadian case, respectively.ECB Working Paper SeriesNo 2203 / November 2018…”

“…studying the case of fiscal federalism in Spain, present empirical evidence of political factors determining the allocation of grants to municipalities Büttner et al (2011). show that, even without lobbying, the fiscal equalization scheme may serve as a strategic vehicle for higher-level governments to pursue self-interested policies.22 This natural experiment was first presented inHolm-Hadulla (2009); it has also been used in a study byRauch and Hummel (2016), which applies it to a narrower research question, however.ECB Working Paper SeriesNo 2203 / November 2018…”

Fiscal equalization as a driver of tax increases: empirical evidence from Germany

“…Empirical research has also explored effects of redistributive state grants to German municipalities (e.g. Buettner 2006;Egger et al 2010;Rauch and Hummel 2016). While this research generally supports causal effects on local tax policy, the mechanism behind the policy response differs slightly from fiscal capacity equalization.…”