Proceedings of the 5th Economic & Finance Conference, Miami

YARDSTICK COMPETITION AND TAX COMPETITION -INTERGOVERNMENTAL RELATIONS AND EFFICIENCY OF PUBLIC GOODS-

YASUYUKI NISHIGAKI, HIDEYA KATO

Abstract:

Several branches of the literature focus on the advantages of the provision of public goods by a local government. Tiebout (1956) indicated that “voting with feet” leads to the optimal provision of local public goods if residents can emigrate from one municipality to another to maximize utility. Due to the free mobility of residents, local governments exhibit an inter-related performance in a competitive environment and are disciplined to achieve efficient provision of public goods, although rather unrealistic conditions, including perfect information and “free mobility” of residents, are pre-requested. The theory of local yardstick competition, in the principal–agent setting with asymmetric information, states that the comparison of the public service level and tax rates of a government with that of nearby localities can provide a useful instrument to assess a government’s performance. By comparing the performance of similar jurisdictions, voters can elect good politicians and send non-performers packing. Due to such a yardstick comparison of residents, local governors are disciplined to exert maximum efforts toward supplying public goods (Besley and Case 1996, Besley and Smart 2007), although they fail in the optimal provision of public goods (Nishigaki et al. 2015). Furthermore, a political inter-relation among neighboring jurisdictions causes interdependence in policy decisions and mimicking of policy variables or tax rates in the yardstick competition. This interdependence of policy or tax rates caused by informational externality is frequently used as evidence of yardstick competition in empirical studies (Besley and Case 1996, Revelli 2006, Nishigaki et al. 2014). Tax competition among local governments, on the other hand, addresses interaction due to inter-jurisdictional mobility of the tax base. By using a competitive two-region model, studies have indicated that an unfavorable externality of loss in the tax base causes strategic behavior in tax setting and an undersupply of public goods arises as a result of intergovernmental competition (Wildersin 1988, Brueckner and Saavedra 2001). These studies have also indicated that even competition among benevolent governments with full information leads to unfavorable results. By introducing the production of private and public goods using the inter-regionally mobile factor of capital stock, this paper investigates tax competition in a yardstick competition model. The harmful effects of under-provision of public goods caused by tax competition and political competition are synthesized in the yardstick equilibrium. Furthermore, it is indicated that the externality caused by the loss in capital stock is internalized through the informational externality of the yardstick comparison.

Keywords: Local Public Goods; Asymmetric Information; Intergovernmental Externality; Yardstick Competition; Tax Competition

DOI: 10.20472/EFC.2016.005.020

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