Mergers in fiscal federalism

• We analyze the impact of the merger of regions in a two-tier territorial organization with regions and cities.
• The merger of regions always increases regional tax rates and decreases local tax rates.
• These results are robust to a change in the timing of the game between regions and cities.

We analyze how the merger of regions affects capital tax competition in a two-tier territorial organization where both regions and cities share the same mobile tax base. We identify three effects generated by the merger of regions that impact, either directly or indirectly, both regional and local tax choices: i) an alleviation of tax competition at the regional level, ii) a scale effect in the provision of regional public goods, and iii) a larger internalization of vertical tax externalities generated by cities. We show that the merger of regions always increases regional tax rates while decreasing local tax rates. These results are robust to a change in the timing of the game.