Federalism, Taxation, and Economic Growth

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Research Paper No. 1929

Federalism, Taxation, and Economic Growth

John William Hatfield January 2006

RESEARCH PAPER SERIES

Federalism, Taxation, and Economic Growth
John William Hat…eld Graduate School of Business Stanford University January 2006

Abstract We show that federalism will lead to higher economic growth. We present a model of endogenous growth where government services, funded by income and capital taxes, are a component of production. In this model a decentralized government will choose tax policy to maximize economic growth, while a centralized government will not do so. Furthermore, these conclusions hold regardless of whether the government is beholden to a median voter or is a rent-maximizing Leviathan. However, a decentralized government will underprovide a consumptive public good. Finally, we show our results are robust to imperfect capital mobility between districts and in such a model that districts with a lower total factor productivity will choose a more growth-enhancing tax policy.

The author may be contacted at hat…eld@stanford.edu. We are particularly obliged to Paul Milgrom and Romain Wacziarg for their guidance during the course of this research. We are also grateful to Syed Nageeb Mustafa Ali, B. Douglas Bernheim, William Hauk, Jr., Patricia MacriLassus, Ben Malin, Hui Li, Yuan-Chuan Lien, Daniel Quint, Antonio Rangel, Azeem Shaikh, and John Shoven for their helpful comments.

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Introduction

Determining the policies that increase economic growth is one of the foremost challenges for today’ economists. These questions are of enormous practical impors tance, as the welfare consequences of even small increases in economic growth can be tremendous.1 And yet, …nding these optimal economic policies is only half the job. Economic policy is not decided by benevolent social planners, but by government o¢ cials, usually with at least one eye to their reelection prospects. We consider the question of how di¤erent political institutions will result in di¤erent economic policies, and hence in di¤erent growth outcomes. In particular, we consider how a centralized or decentralized governance structure a¤ects equilibrium economic policy, and hence economic growth. decisions will enhance growth. We show that decentralizing government policy

It is well understood in the literature that di¤erent political institutions may lead to di¤erent policy outcomes. Persson and Tabellini (2000, 2003) consider many of these questions, such as the e¤ects of electoral regime, existence of a president, etc. from both theoretical and empirical perspectives. The question of how decentralized governance a¤ects economic outcomes, however, is far from settled. The change in economic outcomes from introducing interdistrict interaction was …rst discussed by Tiebout (1956), but we are concerned here with the narrower question of how tax competition between districts a¤ects these outcomes. There are two strands of literature in this area. The …rst, more theoretically based, largely espouses “race to the bottom” conclusions. They argue that tax competition will drive tax rates on mobile factors, such as capital, to be too low, and hence district governments will underprovide consumable public goods (Zodrow and Mieszkowski 1986, Keen and Marchand 1996) and social insurance (Rom et al. 1998). The second strand of literature argues that tax competition drives the districts to choose better economic policies in their quest to acquire and keep capital. Brennan and Buchanan (1980), the foremost proponents of this view, argue that federalism may restrain a Leviathanlike government; competition for capital may place a constraint on how much in rents states can acquire.2 We strive in this paper to unify these views into a comprehensive whole. The key For further discussion of this point see Lucas (1988). There is also a large, more recent literature on the possible bene…ts of decentralization due to a...
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