Vertical tax competition and consumption externalities in a federation with lobbying

We consider a federation with two layers of government, in which Leviathan policy makers levy an excise tax on a consumption good that generates a negative externality and that is produced in an imperfectly competitive market. When both layers of government are allowed to tax, policy choices are affected also by vertical tax competition. In this setting, tax policy in general is not efficient. We then examine how special interest groups may influence tax policy by lobbying the policy makers. We find that, depending on market structure and on the level of the externality, lobbying can improve efficiency, and that tax-base sharing by two layers of government can be more efficient than taxation by a single layer.

► Tax-base sharing by two layers of government can be an efficient tax regime. ► Tax policy swayed by lobbying can be Pareto superior to lobby-free tax policy. ► Tax-base sharing is efficient if the externality linked to the taxed good is large. ► The dispersion of taxing powers may reduce the influence of pressure groups. ► Leviathan politicians are better off when facing lobby groups with opposed interests.