Income distribution, taxation and shifting in a federal fiscal structure

Abstract We study income tax competition in a structure of two adjacent two‐tier (federal‐regional) fiscal federations, where both upper‐tier and lower‐tier authorities tax income in the presence of income shifting within and between the federations. We show that when the federations are symmetric, horizontal competition leads to income‐shifting flows from rich regions (setting higher income tax rates) to poor regions (setting lower tax rates), both within and between federations. Moreover, income‐shifting facilities intensify tax competition, potentially increasing income redistribution from wealthier to poorer regions. However, in the case of asymmetric federations, the relationship between regional income tax rate and tax base and the resulting direction of inter‐regional income‐shifting flows are ambiguous due to the operation of vertical and diagonal fiscal externalities.