Tax competition among local governments: Evidence from a property tax reform in Finland

a r t i c l e i n f o This paper uses a Finnish policy intervention to study tax competition among local governments. Changes in the statutory lower limits to the property tax rates are used as a source of exogenous variation to estimate the responses of municipalities to tax rates in their neighboring municipalities. I do not find evidence of interdependence in property tax rates among Finnish municipalities. The results are in contrast to the earlier empirical literature, using data from other countries, that has mainly found positive interdependence in tax rates. I compare the causal estimates based on the policy change to the commonly used Spatial Lag estimates and Spatial Instrumental Variables estimates, which are based on highly restrictive assumptions. The comparisons suggest that the standard spatial econometrics methods may have a tendency to overestimate the degree of interdependence in tax rates. The theoretical literature on fiscal interaction among local governments is fairly well developed and has identified several potential sources for interdependence in taxation and spending decisions. The implications of fiscal interaction for the efficiency of public service provision and the allocation of resources across jurisdictions have been studied in various settings (see Wilson, 1999, and Wilson and Wildasin, 2004, for reviews). By contrast, empirical research on fiscal interaction among jurisdictions is still relatively scarce and the identification strategies used do not generally meet the standard required for the results to have a causal interpretation. The estimation of the responses of jurisdictions to taxes and spending in other jurisdictions is fraught with endogeneity issues. Firstly, the interdependence of taxation and spending decisions among neighboring jurisdictions leads to two-way causality, which renders Ordinary Least Squares (OLS) estimates of the reaction functions inconsistent. Secondly, tax rates in neighboring municipalities may be driven by spatially correlated unobserved factors that lead to spurious correlation in tax rates. This paper studies municipal property taxes in Finland and utilizes a Finnish policy change as a source of exogenous variation in tax rates to overcome these identification problems. The purpose of the paper is to estimate the responses of Finnish municipalities to property tax rates in neighboring municipalities. In addition, the causal estimates based on the policy change are compared with standard spatial econometrics methods that have been commonly used in the literature. In Finland, municipalities choose property tax rates within limits set by the central government. In the year 2000, the …