Commodity Tax Competition Between Member States of a Federation

This paper characterizes the outcome of tax competition between autonomous fiscal authorities. It treats the case of a two-region economy, where an origin-based commodity tax is levied by each region on a private good to finance a local public good. A second private good is untaxed. We describe regional market equilibria where consumers of each region allocate their purchases according to relative prices, taxes and transportation costs. Optimal tax rates and levels of public good are derived. Fiscal competition arises from the ability of one region to choose its tax rate which can alter the tax base of the other. A non-cooperative fiscal equilibrium (NCFE) is computed and compared to the Pareto optimum. In general, fiscal choices that are Pareto improving in the NCFE never reduce taxes in both regions.