The assignment and division of the tax base in a system of hierarchical governments

Vertical externalities, changes in one level of government’s policies that affect the budget of another level of government, may lead to non-optimal government policies. These externalities are associated with tax bases that are shared or “co-occupied” by two levels of government. Here I consider whether co-occupancy of tax bases is desirable. I examine the optimal extent of the tax bases of a lower level of government (local) and a higher level (state). I find that it is optimal to have co-occupancy in the absence of other corrective policies if commodities in the tax bases are substitutes. Further, if the state government can differentially tax the co-occupied segment of the tax base and the segment it alone taxes it will obtain the (second-best) outcome obtained with other policy instruments such as intergovernmental grants.