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A Second Best Theory Of A Fiscal Federal System

By Motohiro Sato

Abstract

This paper investigates properties of the second best allocation in a fiscal federal system in which both federal tax and intergovernmental grants are involved and the taxation is distortionary. We extend the analysis of Boadway and Keen (1996) and Dahlby and Wilson (1994) by introducing both imperfect mobility and heterogeneous regions. In contrast to the outcomes in the existing works, we find; (i) the second best does not require the equalization of the conventional MCPFs between regions; (ii) in order to replicate the second best, matching grants based on either the local tax rates or tax revenues should be introduced to internalize the tax externality; and (iii) federal tax policy is redundant once the intergovernmental grants are optimized. The irrelevancy of the federal tax implies that optimal fiscal gap is indeterminate. Therefore, it will be argued that the standard framework of fiscal federal model in the literature does not provide a rationale for either decentralization or centralization of the tax system once the federal government is allowed to use sufficient instruments of inter-regional transfers.tax externality, equalization of MCPFs, matching grants, optimal fiscal gap

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