Strategic Interaction in Local Fiscal Policy
Summary
Local governments frequently set tax rates, public spending and service provision while observing the decisions of neighbouring jurisdictions. These interdependent choices, known as strategic interaction, arise through mechanisms such as yardstick competition, spatial spillovers and tax competition. By emulating or differentiating themselves from nearby authorities, localities respond to electoral pressures, revenue shocks and regulatory changes. Such behaviour can enhance accountability and policy innovation, yet may also lead to under-provision of public goods or exacerbate regional disparities. Advances in spatial econometrics have enabled scholars to disentangle direct policy effects from indirect influences, offering nuanced insights into how fiscal decisions diffuse across jurisdictions and shape outcomes in diverse political and economic contexts.
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Technical terms
Yardstick competition: Comparison by voters of their local government’s performance or policies with those of neighbouring jurisdictions.
Spatial spillovers: Indirect effects on a jurisdiction’s fiscal outcomes resulting from policy changes or economic conditions in adjacent areas.
Tax competition: Rivalry among governments to attract or retain the tax base by setting relatively lower tax rates or offering incentives.
Flypaper effect: The tendency for intergovernmental grants or revenues to increase public spending rather than reduce taxation.
Strategic interaction: Interdependent decision-making by local governments influenced by the anticipated reactions of neighbouring jurisdictions.
References
- JUE Insight: Immigrants, social transfers for education, and spatial interactions. Journal of Urban Economics (2023).
- Tax competition effects of a minimum tax rate: Empirical evidence from German municipalities. Journal of Public Economics (2024).
- Strategy of Spatial Panel Estimation: Spatial Spillovers Between Taxation and Economic Growth. Applied Spatial Analysis and Policy (2015).
- Political cycles, spatial interactions and yardstick competition: evidence from Italian cities. Journal of Economic Geography (2019).
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