Tax Competition and Equalization: The Impact of Voluntary Cooperation on the Efficiency Goal

Literature has long learned about the welfare improving effect of equal-ization in tax competition environments. By setting incentives to local authorities, public spending becomes efficient in spite of relying on a mobile resource as the tax base. This paper proves that an equaliza-tion system, which is not decided by an autonomous central planner, but in a common decision process of lower-level governments, is not able to internalize the spillovers of tax competition totally. As bar-gaining requires a certain share of improvements for the regions, a needed compensation within the system results in inefficiencies in the private and the public sector. Additional instruments have to be pro-vided to enhance efficiency. Thereby the constitutional framework to cooperation on equalization can either promote efficiency or equity, a result which is contrary to the literature emphasizing that equalization can imply both