OPTIMAL TAXATION IN A FEDERAL SYSTEM OF GOVERNMENTS

This paper demonstrates that the optimal structure of taxation in a fe deral system of governments is one in which only lower level governmen ts are allowed to tax, and the higher level of government receives its revenues as contributions from the lower level governments. The centr al inefficiency created when multiple levels are allowed to tax is a r evenue externality between governments that is analogous to a common p ool problem. A federal system with multiple levels of taxing authority results in combined tax rates higher than would be optimal, a higher excess burden of taxation, and an inefficiency bias in government spen ding.