Local government responsiveness to federal transfers: theory and evidence

Federal transfers can depend on local fiscal capacity which is measured by local tax bases. The aim of this paper is to understand to what extent and how these transfers affect local tax decisions. We develop a model with two provinces producing one mobile good. The good is taxed according to the destination principle. Final consumers decide to buy the good from the province where it is cheaper. The two provinces engage in tax competition. The introduction of scale economies into the shopping technology generates nonlinear tax reaction functions which make it possible to test the effect of a transfer equalizing local tax bases on tax competition in two complementary tax regimes. Used for this purpose are cigarette and gasoline tax data from Canada. In the case of cigarette tax, it is found that nonlinearity in tax competition is almost entirely offset when equalization holds: tax competition in the two tax regimes become closer. The shopping technology for gasoline gives less scope for scale economies, so that equalization does not affect reaction functions.