Identifying local tax mimicking with administrative borders and a policy reform

This paper exploits an exogenous reform of the local fiscal equalization scheme in the German State of North Rhine-Westphalia (NRW) in 2003 to identify tax mimicking by municipalities in the neighboring state of Lower Saxony (NDS). The reform caused municipalities in NRW to increase their business and property tax rates. I study within the difference in difference (DD) and the spatial lag (SL) frameworks whether municipalities in NDS bordering NRW did react to the exogenous tax increases by NRW municipalities. The DD and SL results suggest that there are no interactions in tax rates. In contrast, traditional SL regressions that rely on variation in neighbors' demographic and political characteristics for identification provide strong evidence for immediate strategic interactions. These results indicate that most of the existing literature overestimates the importance of local tax mimicking.