Timothy J. Goodspeed

Bailouts in a Federation

The recent move towards decentralization in countries such as Spain, Hungary, and South Africa and the difficulties that central governments have had in dealing with fiscal irresponsibility on the part of regional governments in countries such as Argentina, Brazil, and India has made the study of transfer systems one of the most important areas of research in federalism today. A model of a federation is developed in which regional governments act as Nash competitors with each other but are first-movers in a Stackelberg game with the central government. The central government finds that it will maximize its expected votes by increasing transfers as regions borrow. This bail out of regional governments creates a regional soft budget constraint and results in two incentive effects, a common pool effect on tax payments and an opportunity cost effect. The soft budget constraint lowers the opportunity cost of borrowing for the region, but also increases the tax-cost since a portion of the borrowing must be paid for through increased taxes. The common property problem associated with tax payments implies that the increased tax cost must be less than the decrease in the opportunity cost (leading to excessive borrowing) unless the central government increases grants to other regions when it institutes a bailout. Somewhat surprisingly, in the latter case the additional increased taxes may increase costs enough to offset the lower opportunity cost resulting from the bailout, leading to efficient borrowing decisions as in the case of a hard budget constraint. The results are also useful for understanding the empirical estimation of soft budget constraints.

Follow the Leader? Evidence on European and US Tax Competition

This article breaks from the previous empirical literature that estimates Nash tax reaction functions of national governments competing with other national governments assuming that competitors play a Nash game and adjust to a Nash equilibrium in every year. We question this assumption and explore whether one country plays a leadership role in tax competition using data from 1968 to 2008. We test the leadership role of the United States, the United Kingdom, and Germany, and find support for a US leadership role. We also investigate whether countries react differently immediately after watershed tax reforms such as the 1986 US Tax Reform Act or the 1984 UK tax reform. We find some support for a different reaction to the United States following the 1986 US reform, but not for the United Kingdom or Germany.

Tax structure in a federation

Abstract Does national taxation of a base influence the degree to which the local government will use the same tax base? Does the tax rate chosen by one local government influence the choices made by another local government? The theoretical answer to these questions is often in the affirmative because of vertical and horizontal externalities that result when several governments are operating at the same time in a fiscal system. However, little empirical information is available. This paper estimates the impact of horizontal and vertical externalities on the choice of tax rates by local governments operating in a federation. Higher national income tax rates and lower poverty rates are found to lead to lower local income tax rates.

Tax competition and tax structure in open federal economies: Evidence from OECD countries with implications for the European Union

Tax competition arguments suggest that a government that operate in an open economy (such as local governments) should not and will not rely on non-benefit taxes, such as the income tax. Yet we observe reliance on income taxes by local governments in many countries, and such reliance changes over time. Evidence from a panel data set of 13 OECD countries over the period 1975-1984 suggests that competition between levels of government (resulting in a vertical fiscal externality) and between governments at the same level (resulting in a horizontal fiscal externality) provide some economic rationale for these changes. Moreover, the evidence indicates that the vertical and horizontal fiscal externalities interact. These results have some interesting implications for fiscal policy in the European Union, particularly as the EU continues to evolve. One implication for the EU is that enlargement that increases tax base disparities within the EU (and is not accompanied by an EU-level income tax) will tend to lower national income tax rates, although this must be qualified because it also depends on the mobility of the population. A second implication is that fiscal expansion of the EU to include an EU-level income tax may tend to lower the reliance of national governments on income taxes through the vertical externality, but may also tend to equalize tax bases across countries, and so increase reliance on national income taxes through the horizontal externality.

A re-examination of the use of ability to pay taxes by local governments

Abstract The orthodox view of local finance in the U.S. is that local governments should abstain from using ability to pay taxes because migration would result in a misallocation of resources and would nullify any attempt to redistribute income. This paper uses a general equilibrium model of a metropolitan area to examine the efficiency and redistributive properties of local income taxation relative to local head taxes. Contrary to the orthodox assertion, the results indicate that local governments can use income taxation without substantially misallocating resources. In addition, some redistribution results from the use of local income taxes.

Fiscal decentralization policies and sub-national government debt in evolving federations

As part of a process of democratization, many countries spanning Europe, Latin Amertica, Africa, and Asia are reorganizing their governments by devolving fiscal responsibility and authority to newly empowered regional and local governments. Although decentralization in each country proceeds differently, a common element tends to be an initially heavy reliance on central government grants to fund regional spending. We develop a theoretical model of regional borrowing decisions in which the incentives for regional borrowing depend crucially on how the regions expect the federal system of finance to evolve. We examine the implications of the model using data on Spanish regions for the period 1984-1995 and find evidence that regions may be borrowing inefficiently in response to incentives imbedded in the Spanish system of fiscal decentralization.

Are Other Government Policies More Important than Taxation in Attracting FDI

This paper attempts to broaden the existing empirical literature on foreign direct investment by incorporating government expenditures (both investment in infrastructure and consumption) as well as tax, classical location factors, institutional factors that may hinder business investment (such as corruption), and agglomeration effects. We investigate the determinants of FDI inflows in two unbalanced panel data sets of 47 countries from 1995-2002 and 37 countries from 1996-2002. We use fixed country and year effects and examine different infrastructure measures. The evidence indicates that lower taxes, lower corruption, and better infrastructure attract FDI. Government consumption expenditures negatively impact FDI inflows. The magnitude of the response of FDI to our investment in infrastructure is similar to that of corruption and taxes in elasticity terms.

Public Policies and FDI Location: Differences Between Developing and Developed Countries

Host country government officials in developing and developed countries alike would like to know the impact of their public policies on foreign investment in their countries. Unfortunately, the literature does not provide a single view, and there are likely to be differences between developing and developed countries. This paper examines the impact of three host country government policies on the host’s FDI stock: taxation, good governance, and infrastructure. We focus on whether the impact of these factors on FDI differs depending on the level of development of the host country. The regression results indicate that FDI is sensitive to host country taxation in developed countries, but not in developing countries; FDI is sensitive to host country governance measures and corruption in developing countries but not developed; and FDI shows sensitivity to host country infrastructure quality in both developed and developing host countries.

Local income taxation: An externality, Pigouvian solution, and public policies

Abstract Traditionally, public finance economists have suggested that the migration incentives created by taxes on income make such taxes inferior to head taxes for local governments. This paper develops this argument in a model in which the choice of tax instrument is endogenously determined by majority rule in each jurisdiction. An asymmetric income distribution and majority rule can lead a local government to choose income taxes over head taxes. Although income is exogenous in the model, taxes on income are Pareto inefficient because of mobility. The inefficiency can be thought of as an externality created by local income taxes; the Pigouvian solution thus becomes a natural corrective mechanism to recommend. Public policies such as equalizing grants and the deductibility of local taxes are compared to the Pigouvian solution.

The Nonprofit Sector's Capital Constraint: Does It Provide a Rationale for the Tax Exemption Granted To Nonprofit Firms?

The exemption of the nonprofit sector from the corporate income tax is an implicit subsidy that has received little attention in the nonprofit literature A fundamental question concerning this subsidy is its rationale. The present analysis suggests that the theoretical basis for the rationale previously proposed by Hansmann, that the nonprofit sectors capital constraint justifies its tax exemption, relies heavily on the output effect of exemption. The article first suggests that the nonprofit sectors capital constraint might not be effective. Granting an effective capital constraint, the equivalence of the ration to a partial factor tax is used to show the effect of the constraint on the allocation of resources. If the tax exemption is targeted to the rationed factor, it can have no effect on the misallocation of resources because the rationed factor is immobile. If the tax exemption falls on mobile capital, that capital can avoid the tax by moving to the nonprofit sector. This must worsen the production distortion but might improve allocative efficiency. For an overall improvement in welfare, the improvement in allocative efficiency must outweigh the additional production distortions. Thus the Hansmann rationale for exemption of the nonprofit sector is similar to the rationale for exempting a sector that produces goods that are public in nature: the exemption provides a supply side subsidy to nonprofit output for both cases. In either case, the exemption is inherently a second-best method to achieve an increase in nonprofit output.