Optimal income taxation and decentralized fiscal federalism☆

a r t i c l e i n f o This paper concerns redistribution and public good provision under asymmetric information, which are here ingredients of a policy-problem facing each member state (nation) of an economic federation with decentralized leadership. Each member state is assumed to have its own redistributive policy and pattern of public consumption, whereas the federal level redistributes (ex-post) between the member states. The results show how and why federal ex-post redistribution may modify the use of income taxation and public good provision at the national level, relative to the policy outcome in the absence of a federal government, as well as how the national policy incentives depend on whether or not the federal government uses distortionary taxes. There is a growing literature dealing with optimal nonlinear taxation and public good provision under asymmetric information. 1 Earlier studies in this area are typically based on models of a single jurisdiction with one single government. Real world economies, on the other hand, are often characterized by several levels of government, where each such level has responsibility for its own activities and funds. Therefore, although earlier research gives valuable insight into the incentives underlying tax and expenditure policies, it tends to abstract from the institutional structure within which the public policies are decided upon. In a European context, this fiscal federalism argument is probably even stronger than before, as part of the redistributive policy is now formally decided upon at the European Union (EU) level. An important question, therefore, is how the redistribution policy carried out by a supranational authority affects the use of income taxation and expenditure policies at the national level. This is also the basic question to be addressed by the present paper. To be more specific, this study deals with optimal redistributive income taxation and public good provision as a policy-problem facing each member state of an economic federation, which is characterized by decentralized leadership. The concept of decentralized leadership is meant to imply that the lower (e.g. national) level of government acts as first mover (and has commitment power) vis-à-vis the federal level. The idea behind this extension of the optimal income tax model is to combine a framework for domestic redistribution and public consumption with a decision-structure of particular relevance for Europe. It has been argued in earlier research (which is further discussed below) that the EU exemplifies an economic federation with …