Fiscal federalism revisited

We analyze how constitutional restrictions on tax base within a federation affect the nature of Pareto-improving directions or tax reform and the desi gn of optimal federal taxes. We show that constraints on federal taxation e ntail production, inefficiency at the optimum. except under very restrictiv e circumstances. In passing, we show that using consumer prices as control variables-a standard procedure in tax-reform analysis-rather than the taxes themselves, leads to incorrect conclusions when not all taxes or prices ca n be controlled. Journal of Economic Literature Classification Numbers: D61 , H21, H70. (C) 2000 Academic Press.