Horizontal and Vertical Tax Externalities in a Multicountry World

Recent contributions on tax competition recognize the interaction between both horizontal and vertical tax externalities in a single federation. In this paper, we extend the theoretical analysis to a framework with multiple federations (a Union). We show that the relative size of a federation in the Union determines not only the extent but also the direction of the tax ine¢ ciency. The equilibrium state tax is lower in relative small countries but surprisingly, vertical externalities are more likely to dominate there, i.e. for a relative small federation, the non-cooperative local tax rate is lower than for a relative large federation but still higher than the one observed in absence of tax competition. This result seems to contradict recent theoretical findings where a lower equilibrium state tax is followed by a dominant horizontal externality.