A theory of interregional tax competition

A general equilibrium model is constructed to study tax competition, where local governments compete for capital by holding down property tax rates and public expenditure levels. An exact definition of tax competition is provided, and both the existence and nonexistence of tax competition are shown to be theoretically possible. It is argued, however, that tax competition must occur under empirically reasonable conditions. Inefficiency in public production is also explicitly modeled. The amount of capital used to produce a given level of public service output is shown to be greater than that which is required to minimize costs evaluated at the prices facing private firms.