Does Federalism Lead to Excessively High Taxes?
The central purpose of this paper is to clarify the interrelationship, and balance, between horizontal and vertical externalities in archetypal federal structures. The authors take the standard model of horizontal capital tax competition–that of Wilson (1986) and Zodrow and Mieszkowski (1986)–and superimpose a federal government. The authors ask the following questions: Will taxes be too low in equilibrium (the horizontal externality dominating), as is usually supposed, or too high (the vertical externality dominating)? How is the balance between horizontal and vertical externalities affected by the nature of the strategic interaction between federal and state governments? The authors conclude that the vertical externality will dominate if the aggregate tax base of the federation is sufficiently responsive to the state tax instrument. The horizontal externality will dominate, on the other hand, if the interstate mobility of the tax base is great enough. If conventional advice is foll
