Instituto de Economía

Abstract: We study the optimal degree of fiscal decentralization in a federation where two regions differ by their capital endowment. Two regimes are compared on efficiency grounds: partial and full decentralization. Under partial decentralization, regional governments have no tax powers and rely on central bailouts to refinance incomplete projects. Under full decentralization, regional governments refinance incomplete projects through capital taxes, in a context of tax competition. We show that when regional disparities are small, an increase in regional asymmetries actually favors tax decentralization. On the other hand, when regional disparities are large enough, the degree of regional asymmetry can be irrelevant for the regime comparison. Finally, tax decentralization can be optimal even under a Rawlsian welfare criterion (i.e., extreme inequality aversion).