Effects of Overlapping Tax Bases in a Growing Economy

We examine how the overlap of tax bases in a federal economy affects economic growth. In our model the central and local governments have different objectives and each government finances its own public service using taxes levied on the same income tax base. The optimal tax rate for the growth-maximizing central government is affected by the tax strategies of the welfare-maximizing local government. This paper demonstrates that the central government is compelled to choose a lower tax rate than the one that leads to the highest economic growth rate. Furthermore, we derive the normative implication that the tax-base overlap might lead to inappropriate taxation decisions because neither level of government bases its taxation decisions on the true marginal cost of raising its tax revenues.