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    • The phenomenon of tax competition arises when

    2018-11-15

    The phenomenon of tax competition arises when the decisions of fiscal and tax policy taken by a level of government affect the tax revenues of other governments in the federation (Mintz and Tulkens, 1986; Goodspeed, 1998). Thus, each government entity has the ability to modify the size of its tax ST 2825 when adjusting its tax rates at the expense (or benefit) of its neighbours (Mintz and Tulkens, 1986). In this context, fiscal interactions can lead to two types of externalities: one horizontal and one vertical. In the first case, the externality occurs when governments at the same level in the federation compete for mobile revenue sources (e.g., capital, labour, firms), setting their tax rates to attract them into their territories. In the second case, the externality arises when different levels of government (e.g., state and federal governments) are taxing the same economic base. This co-occupancy may be explicit or implicit when tax bases are somehow inter-related in some economic sense. The vertical interaction can result in overtaxing, creating a situation in which the tax rates are higher than those that would prevail in the social optimum (Keen and Kotsogiannis, 2002). In both cases, the decisions regarding the adjustment of tax rates in one level of government end up affecting the tax revenues of the other level of government, whether they are distinct or not. The theoretical model proposed by Flowers (1988) and its developments made by Boadway and Keen (1996), Boadway et al. (1998), Keen (1998), Flochel and Madies (2002) and Keen and Kotsogiannis (2002, 2003, 2004) show two important aspects of vertical interaction: interdependence among different government levels and the equilibrium levels of taxation. The theoretical analysis of interdependence explores how the lowest government levels react to a change in the tax rate of the highest level of government. The theoretical prediction for this analysis is generally ambiguous in the sense that there may be positive or negative reactions from the lower levels of government in response to increases in the tax rates of the highest level. An increase in taxes at one government level results in a revenue reduction for another government level, due to contraction in the shared tax base. In the equilibrium, the result is usually an over-taxation of the common base at higher tax rates. Empirical studies on vertical tax competition have been focusing on the estimation of a reaction function that shows how subnational governments respond to tax policy choices from the federal government. The works of Besley and Rosen (1998) and Goodspeed (2000) were the first to analyse vertical tax competition using this strategy. However, both studies do not take into account the existence of horizontal tax competition among subnational levels of government. Subsequently, the works proposed by Hayashi and Boadway (2001), Esteller-Moré and Solé-Ollé (2001), Brulhart and Jametti (2006), Devereux et al. (2007), Karkalakos and Kotsogiannis (2007) and Fredriksson and Mamun (2008) introduced tax interaction among subnational levels of government (horizontal tax competition) in this type of analysis. Based on research carried out by Devereux et al. (2007) and Fredriksson and Mamun (2008), Politi and Mattos (2012) analyse the vertical and horizontal externalities in cigarette and gasoline taxation in Brazil, using a database covering the 26 Brazilian states (the capital Distrito Federal was excluded from the analysis) between the years 1995 and 2007. As state tax rates, the authors used the ICMS tax rate for cigarettes and gasoline; as federal tax rates, the IPI for cigarettes and CIDE for fuel were used. The federal tax rates vary only over time, remaining constant for each state in the analysis. The results point to empirical evidence of vertical tax competition in the cigarette case. This paper is divided as follows. Section 2 includes a brief analysis of indirect taxation and the Brazilian tax system and, subsequently, an overall analysis of the theoretical models’ structures that considers the existence of externalities in the context of tax competition. Section 3 discusses the econometric methodology for analysing vertical tax competition and the database used. Section 4 includes the results of the estimated reaction functions and the econometric tests conducted to guide the choice of assumptions about the behaviour of strategic levels of government. The final section summarises the main conclusions from the results presented by the econometric tests performed, as well as their possible implications related to the economic theory.