Academic journal article New England Economic Review


Academic journal article New England Economic Review


Article excerpt

Daphne Kenyon's paper provides a stimulating and thought-provoking review of the theoretical literature on interjurisdictional competition for economic development.(1) In the paper she clearly articulates several alternative definitions of interjurisdictional competition and then spells out very clearly several alternative theories. Her approach is to focus on the normative content of the theories developed in the papers she reviews. The central question addressed in her review is whether economic theory can tell us if, at least on conceptual grounds, interstate competition enhances allocative and productive efficiency. We know that, subject to some limiting assumptions, economic competition leads naturally towards economic efficiency. The central question addressed by Kenyon's paper is how well this powerful result about the operation of the market translates to competition among governmental units.

Although she does not say so directly, Kenyon's review of the literature leaves one with the firm impression that the theoretical literature on interjurisdictional competition is not very well developed. In fact, a glance at the program for today's symposium indicates that with the exception of Kenyon's paper, the agenda concentrates on empirical issues related to interjurisdictional competition. This division between theoretical and empirical appears to reflect the fact that while considerable progress has been made in addressing a number of empirical issues, we are a long way from developing a comprehensive theory of interjurisdictional competition.

Theoretical models can make two important contributions to the study of interjurisdictional competition. First, they can help structure the empirical analyses and suggest specific testable hypotheses. Second, they help provide answers to the normative question Kenyon posed in the title of her 1988 ACIR study - "Interjurisdictional Tax and Policy Competition: Good or Bad for the Federal System?"

In my view, for the purposes of this conference the most important of the papers Kenyon reviewed is the one by Oates and Schwab (1991). Although she characterizes the Oates and Schwab model as in the Tiebout tradition, it is more accurately the converse of Tiebout. Tiebout posits competition among jurisdictions for mobile individuals, while Oates and Schwab assume that individuals are immobile, and local governments compete to attract mobile capital. Local governments actively compete for businesses by choosing a mix of services to attract businesses. Oates and Schwab demonstrate that, in such a competitive environment, all local taxes will become benefit taxes. Thus, for both residents and businesses, the taxes they pay will exactly equal the value they place on the public services they receive. Oates and Schwab then proceed to show that their competitive model will result in an economically efficient allocation of resources.

Like all models based on perfect competition, Oates and Schwab need to make a number of quite restrictive assumptions. They nevertheless argue that their model can serve as a useful benchmark in discussions of interjurisdictional competition. Both their model and their conclusions echo the basic insight of tax incidence theory in a competitive framework. The ultimate burden of any tax falls on immobile factors of production or immobile individuals. Thus, to the extent that capital is mobile across jurisdictional boundaries, local government residents will be unable to shift a portion of their tax burden onto businesses. Any attempt to increase taxes on business capital above the value of services received by businesses will result in the out-migration of capital.

The important lesson here is that in designing economic development strategies, governments should aim to set tax rates on business capital approximately equal to the public services provided. Only in circumstances where capital is tied to immobile factors or to location-specific factors will it be possible, in the long run, to levy taxes on business capital that are in excess of the value of services provided to business. …

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