Multi-stage Taxation by Subnational Governments: Welfare Effects

This paper analyzes multi-stage taxation by provinces in a federal country, using a twogood, two-province, two-stage successive differentiated-product symmetric oligopoly model, where each producer is located in a province and sells its product through exclusive retailers located in both provinces. Retailers compete for consumers a la Bertrand with differentiated products. The producer-retailer setup allows provincial governments to raise taxes on both upstream and downstream links of the value chain. We solve a simultaneous and non-cooperative tax competition problem, where (symmetric) provinces choose tax rates to maximize welfare subject to a revenue constraint. We find that provinces set tax rates to either raise revenue at only one segment of the value chain or use a combination of upstream and downstream taxation. This choice is determined by the revenue requirement, the size of the market and the degree of downstream competition. We characterize and discuss each possible case. Comparing the results of this model with the Leviathan case (analyzed in a previous paper by the authors) where governments behave as revenue maximizers, we find that there is a threshold on revenue requirement such that welfarist governments tend to behave qualitatively similar to Leviathan governments when revenue need exceed the threshold: they both choose a combination of taxes if products have some degree of heterogeneity, whereas they rely on downstream taxation when products are homogeneous. This way we provide a rationale for raising taxes on successive taxation even when governments internalize the effect of successive taxation on welfare.