Vertical fiscal externalities in a federation

We examine vertical fiscal externalities in a model where a state government provides a productivity-enhancing public input and both the state and the central government tax wages and profits. Previous literature has emphasized the negative tax externality that occurs when two levels of government impose distortionary taxes on the same tax base. We show that an increase in the state government’s tax rate on wage income can increase federal revenues if the federal government imposes an ad valorem tax on employees’ wages and the demand for labour is inelastic. We also show that an increase in the provision of the public input can either increase or reduce federal tax revenues, leading to either under- or over-provision of the public input by the state government.