Are Local Tax Rates Strategic Complements or Strategic Substitutes?

The identification of strategic interactions among local governments is typically plagued by endogeneity problems. This paper proposes an identification strategy that makes use of a multi-tier federal system. State-level fiscal reforms provide an arguably exogenous source of variation in tax rates of local jurisdictions. Moreover, state borders spatially bound the effects of state-level fiscal reforms across areas that are otherwise highly integrated. Using the fact that local jurisdictions located close to a state border have some neighbors in another state, I propose to instrument the (average) tax rate of neighbor jurisdictions with the state-level tax rate of the neighboring state. I use this instrument to identify strategic personal income tax setting by local jurisdictions in Switzerland. In contrast to most of the existing empirical literature and to all results based on standard instruments, I find that tax rates are strategic substitutes in most cases. Tax rates are found to be strategic complements only in the context of large tax cuts.