Unemployment, tax competition, and tax transfer policy

The reduction of capital tax rates witnessed over the past two decades has been motivated by the wish to boost investment and reduce unemployment. Previous models of tax competition have explored the consequences for capital allocation in great detail, but have mostly been silent on the employment effects due to the assumption of a perfect labor market. To address the impact of tax competition on employment and public good provision, this paper reconsiders the analysis in the presence of a labor market imperfection that generates unemployment. We incorporate a wage rigidity and intergovernmental transfers financed by the labor income tax into the standard tax competition model to explore the outcome of federal–state policy interaction. The key factors in determining the efficiency are the capital–labor substitutability/complementary and the cost of the efficient level of public good supply relative to the ability of the labor income to generate revenue. When the labor income tax is insufficient for financing, there can only be efficiency if the aggregate externality is negative—but this outcome is only one of multiple equilibria. We also show that federal government leadership is effective to provide public goods efficiently by state governments if capital and labor are substitutes.