A Fiscal Federalism Approach to Optimal Taxation and Intergovernmental Transfers in a Dynamic Model

In this paper, we study the optimal choices of the federal income tax, federal transfers, and local taxes in a dynamic model of capital accumulation and with explicit game structures among private agents, the local government and the federal government. When the federal government is the leader and the local government is the follower in a Stackelberg game with both the consumption tax and property tax available to the local government, the optimal local property tax is zero, and local consumption tax is positive. But federal transfers to the local government are negative, and the federal income tax can be positive or negative. In this case, the local consumption tax is used to finance both local and federal public spending.