DO LOCAL GOVERNMENTS USE THEIR TAX BASES EFFICIENTLY

This paper analyzes an economy with multiple governments and with mobility of individuals across jurisdictions, where each government is constrained to raise revenue for public expenditures using distortionary taxes. A government is said to be competitive if the total benefits and costs of its decisions, including the excess burden, are perceived to be internalized. The competitive equilibrium allocations are not constrained efficient in general: There exists another set of distortionary taxes and public expenditures such that, when private sector behavior adjusts to maintain equilibrium, all individuals in the economy are better off. Thus competitive, decentralized decision making does not lead to an efficient use of the available tax instruments. It is also shown that the source of the failure can be interpreted as a missing market, and the form of the best decentralized remedy, which involves pricing the tax base, is derived. © 1992.