Vertical Tax Externalities in the Theory of Fiscal Federalism

Federal structures create the possibility of vertical tax externalities between levels of government, with the private sector's response to the tax policy decisions of one level affecting the tax base of the other. Such effects arise most obviously when both levels of government co-occupy the same tax base. This paper reviews and extends recent results on the implications of such externalities for the relationship between state and federal tax rates, the equilibrium levels of these taxes, the (ir)relevance of experience in federal countries for analyzing international tax issues, the pattern of intergovernmental grants, and the assignment of tax powers. [JEL H3, H7, H21].