Fiscal equalization and the tax structure

Abstract

This paper studies the impact of redistributive fiscal equalization transfers on the choice between a distortionary capital tax and a non-distortionary land tax at the local layer of government. In a standard tax competition model, the paper shows that this impact is ambiguous in that, depending on the motives driving local policy choices, fiscal equalization may either induce a more or a less distortionary tax structure. Using a natural experiment from German municipal finance, the paper provides empirical evidence in support of the latter prediction, i.e. fiscal equalization tilts the tax structure towards less distortionary tax instruments.