Vertical versus horizontal tax externalities

Yet, the lower-level authorities will not fully internalize the impact of their decisions on the size of the federal tax base, since their subjects only receive a fraction of the federation tax income. [...] In a federation with a given relative size of federal and state governments (determined in turn by citizens preferences for federal and local public goods), the balance between horizontal and vertical externalities is determined, on the one hand, by the elasticity of the federation- wide tax base relative to the consolidated federation tax rate, and, on the other hand, by the elasticity of the sta [...] Keen and Kotsogiannis (2002) show that the strength of vertical externalities increases in the tax elasticity of the federation tax base and decreases in the tax elasticity of the state tax base. [...] The main change is that we switch the concave part of the utility function to the investment destination that is of interest (the domestic economy in our case, the second period in theirs). [...] The two determinants are (i) the elasticities of the public goods in the utility function ("g and "G), and (ii) the sensitivity of the rate of return to changes in the state tax rates ( @ @t ), which in turn depends on the elasticities of demand and supply of capital (see (5)).