Does Revenue Equalisation Mitigate Tax Competition? Ad Valorem Taxation in a Federation

In this paper, we model a federal economy where perfectly mobile labour supply is taxed on an ad valorem basis by the federal as well as lower-level (state) governments. We find that either under- or overtaxation occurs, under similar conditions as in Keen and Kotsogiannis (2002, 2004). However, the neat trade-off between positive horizontal externalities and negative vertical externalities breaks down entirely in our ad valorem setting. Precisely because of this ambiguity, decentralizing the unitary outcome via revenue equalisation becomes far more complex than under unit taxation. Only when the marginal valuation of public provision is on par with private consumption, can we replicate the clear-cut, efficiency-enhancing equalisation formulas given by Kotsogiannis (2010) and Bucovetsky and Smart (2006)