Optimal Taxation in a Federal System of Governments

Seminar paper from the year 2011 in the subject Economics - Finance Christian-Albrechts-University of Kiel (Department of Economics) course: Seminar in Public Economics and Social Policy: Federalism and (De)Centralization language: English abstract: An implemented tax system causes distortions which leads to a minor overall welfare level compared to a system without taxes. This deviation in social welfare is often denoted by excess burden or dead weight loss (DWL) of taxation. So the traditional optimal taxation approach comprises the implementation of a tax system which minimizes the excess burden and hence the distortions caused by the levied taxes. Therefore the policy maker has to anticipate possible behavioral adjustments of the market participants when choosing its optimal tax policy. Assuming the policy maker will do so all effects (i.e. distortions) caused by the tax system will be internalized which means that no fiscal externalities would arise from implementing the (optimal) tax system. However the traditional optimal taxation approach abstracts from any intergovernmental relations as the existence of only one government and accordingly only one level with fiscal jurisdiction is assumed. The question here is whether and to what extent federal structures (i.e. multileveled government structures) affect the optimal tax policy decision.The first attempt to take into account the characteristics of a federal systemrelated to optimal tax policy goes back to Gordon (1983) who applied the methodologyof the traditional optimal taxation approach to fiscal federalism. Therein eachunit of government (i.e. the federal and usually several state governments) decidesindependently how much of public goods to provide and in particular which taxpolicy to use in funding the provided public goods. Hence we now consider a decentralizedform of decision-making in which each unit of government chooses theoptimal tax policy in the best interest of its own residents.