Regional Tax Competition: Some Lessons from Recent Spanish Fiscal Reforms
Abstract: The main objections to fiscal and institutional competition are based on the “race to the bottom” theory. According to it, competition, reducing the tax burden, also reduces public expenditure to a suboptimal level. But this theory assumes: a/ that governments can identify the optimal level of public expenditure; and b/ that governments have incentives to fix public expenditure at that level. And both assumptions are wrong. If we assume that the main objective of governments is to have a high level of revenues in order to produce more public and merit goods to “buy” votes and stay in power, competition among jurisdictions can be explained as a prisoner’s dilemma, in which the non cooperative solution is the best outcome for taxpayers. To raise taxes, regional governments can either form an oligopoly or reduce their own self-government and centralize decisions at a higher level (national government or European Commission) Both oligopolies and centralization would maintain taxes higher than in a competitive equilibrium. But there is a substantial difference: oligopolies are not stable, since every state or region has incentives to breach the collusion agreement. The second part of the paper presents some experiences from Spanish fiscal federalism. Two examples of regional tax reforms are studied: the reform of inheritance tax and the reform of wealth tax (In Spain both taxes are subnational and are regulated by regional governments).These two examples show that the only effective strategy for governments to avoid fiscal competition is to centralize tax power.
