Interaction between federal taxation and horizontal tax competition: theory and evidence from Canada

The aim of this paper is to determine to what extent and how federal taxes affect local tax decisions. Testing the impact of an increase in the federal tax on horizontal tax competition with Canada-US data for 1984–1994, it finds evidence that an increase in federal tax makes horizontal tax reactions weaker. This is because an increase in federal tax raises the cost, in terms of utility of income, of a unit increase in the province’s tax rate. On the methodological side, it is possible to estimate the impact of the federal tax on the fiscal policy of the province without neglecting control for year effects, which cannot be used in the empirical literature because they are perfectly collinear with the federal tax.