Dynamic Optimal Fiscal Policy in a Transfer Union

Abstract

Transfers between regions within a federal or supranational entity are highly prevalent and may yield substantial benefits; however, such transfers are also likely to have an impact on the involved regions' incentives to tax and spend and thereby efficiency. This paper studies theoretically and quantitatively how the taxation of strategically-acting tax authorities affects their optimal fiscal policy in a dynamic model. Fiscal policy is composed of source-based capital taxes, labour taxes, government consumption, productive infrastructure, and bonds. The global capital stock evolves endogenously due to private agents' optimal savings decisions as in a neoclassical growth model. Labour taxes, government consumption, and infrastructure are all declining functions of the share of government revenues which are transferred. Capital taxes are surprisingly increasing in transfers in the short run, but unaffected in the long run. In the short run, capital taxes are too low and infrastructure spending is too high from a global welfare perspective in the absence of transfers, whereas both are at the efficient level in the long run. The dampened capital-tax and infrastructure competition during the transition means that economic efficiency and thus welfare paradoxically increase for low levels of transfers, even though there are no redistributive gains from transfers. (Copyright: Elsevier)