Interaction between vertical and horizontal tax competition: evidence and some theory.

The aim of this paper is to determine to what extent and how federal taxes affect local tax decisions. Testing the impact of an increase in the federal tax on horizontal tax competition with Canada-US data for 1984--1994, we find evidence that an increase in federal tax affects horizontal tax competition. The novelty of our approach is that it indirectly tests the effect of an increase in federal tax on provincial tax, by testing whether provincial reaction to an increase in neighboring tax changes according to the federal tax level. The test allows for control of yearly macroeconomic shocks by inserting dummies for each year. These are not used in the empirical literature on vertical tax competition because they would cause perfect collinearity with the federal tax.