(Uncontrolled) aggregate shocks or vertical tax interdependence? Evidence from gasoline and cigarettes

Besley and Rosen (1998) were the first researchers to test empirically for the presence of vertical tax externalities, examining the case of unit taxes on gasoline and tobacco. However, they did not take into account the price differences across states that arise because high cost areas pay less in real terms than low cost areas, since federal unit sales taxes on cigarettes and gasoline do not differ across states. Consequently, we propose that vertical tax competition can be estimated by using a federal tax variable that is expressed in real terms and thus shows crosssectional variation across states. To estimate real prices we deflate all financial variables using the House Price Index (HPI), which is disaggregated by states. This empirical strategy enables us to disentangle the vertical interdependence between state and federal tax rates from aggregate shocks over time. We use U.S. data from 1975-2006 on gasoline and tobacco taxes, and find significant horizontal tax competition, but no vertical tax reactions. The results are robust to the period analyzed.