Fiscal Federalism Revisited
Abstract We analyze how constitutional restrictions on tax bases within a federation affect the nature of Pareto-improving directions of tax reform and the design of optimal federal taxes. We show that constraints on federal taxation entail production inefficiency at the optimum, except under very restrictive circumstances. In passing, we show that using consumer prices as control variables—a standard procedure in tax-reform analysis—rather than the taxes themselves, leads to incorrect conclusions when not all taxes or prices can be controlled. Journal of Economic Literature Classification Numbers: D61, H21, H70.