The local distribution of endowments matters: Modelling tax competition with heterogeneous local residents

Dae Jin Kim - University of Seoul, Korea
In Kwon Park - University of Seoul, Korea


http://usj.sagepub.com/content/early/2016/09/08/0042098016665941.abstract


The Korean central government introduced a property tax hike in 2004 as a redistributive policy, bringing as high as a 200% increase in the property tax. This action brought about dynamic interactions between the central and local governments and between local governments, particularly in Seoul Metropolitan Area (SMA). We found that in these interactions the SMA residents were very sensitive to the tax policy of the progressive central government, and acted as home-voters as Fischel (2001) argued. The owners of highly valued home especially opposed the policy and supported the property tax cuts by their local governments, because the residential estate asset was the most valuable one of only a few assets they owned. Local governments competitively responded to their constituents in the form of property tax cuts for the pre-electoral competition (Downs, 1957).


What attracts our attention in this occasion is that the local distribution of home values matters in the race of tax cuts. Home owners’ movements against the property tax hike were observed more frequently in the communities with relatively left skewed distributions of home values. Since the proportion of relatively upscale homes is larger in those communities than in others, more home owners there prefer a low property tax rate. The existing literature on tax competition, however, does not take into account the distribution of resource endowments, but assumes that local residents are homogeneous in endowments. Given this gap between the reality and the literature, we approach the tax competition of the SMA with the viewpoint of public choice, constructing a model with heterogeneous individuals in resource endowments. 


This study bases inter-local tax competition on local governments’ behaviours of maximising the utilities of tax payers with different economic conditions. The difference in labour and capital endowments of individuals brings the pre-electoral competition about the property tax rate or political actions by home owners, which in turn affects the tax competition. The median voter theory suggests that the local government in this case responds to the median voter’s preference to gain a majority of constituents’ supports as the median represents the majority. Our theoretical model incorporates this theory into the tax competition framework, and predicts that the local distribution of resource endowments affects not only a municipality’s decision on the tax rate but also the sensitivity to its neighbours’ tax cut. We employed the spatial panel analysis to test the theoretical model. A panel dataset for the SMA municipalities in 2004-2006 are used for the empirical analysis. The empirical analysis verifies the two main expectations as follows.


First, the results of spatial econometric analyses consistently indicate a positive interdependence of the property tax rates among municipalities. This implies that positive-sum tax competition in the SMA occurs: holding all other things constant, if one local government cuts the tax rate, others also cut the tax rate strategically. Also, this reaction pattern is stronger as local jurisdictions are closer to each other. These results confirm that the Tiebout’s (1956) tax competition theory is valid for analysing the strategic tax interaction among local governments. It is meaningful in that despite abundance of discussion on this topic, there are not many empirical studies supporting the theory with rigorous methods as in this study (Brueckner and Saavedra, 2001).


Second, the local distribution of resource endowments, as measured by skewness of home value, affects the property tax rate and the spatial dependence of tax rates respectively. In a municipality where a majority of constituents are relatively highly endowed, the local government is more likely to adopt a lower tax rate (choosing a higher tax cut) to gain the majority’s supports. As high-priced home owners, they prefer a low property tax rate, making the local government cut the tax rate in response. This confirms the theoretical prediction of the previous studies of pre-electoral competition (Downs, 1957; Persson and Tabellini, 2000; Borck, 2003). The municipality is also more sensitive to its neighbouring municipalities in the race of tax cut. Because the majority of its constituents watching tax cut dominoes of the metropolitan area push the local government to cut its tax rate, it is more likely to participate in the tax cut race. These findings support that the pre-electoral competition of the property tax has an impact on the spatial dependence of tax rate choices by local governments as well as the local government’s internal decision making on the tax rate. 


In sum, this study theoretically elaborates that the local distribution of resource endowments affects both the level of tax rate and the degree of sensitivity in tax competition, and empirically confirms the theory using a panel dataset for the SMA municipalities. The novelty lies in the fact that we incorporated the heterogeneity of individuals’ resource endowments into the tax competition framework both in the theoretical and empirical models. The results also underpin the median voter theory which has been rarely tested with reliable statistical methods despite its reputation as the most widely known theory of public choice.


References

Borck R (2003) Tax competition and the choice of tax structure in a majority voting model. Journal of Urban Economics 54:173–180.

Brueckner JK and Saavedra LA (2001) Do local governments engage in strategic property-tax competition? NationalTax Journal 54(3): 231-253.

Downs A (1957) An economic theory of political action in a democracy. The Journal of Political Economy 65(2): 135-150.

Fischel WA (2001) The Homevoter Hypothesis: How Home Values Influence Local Government Taxation, School Finance, and Land-Use Policies. Cambridge, MA: Harvard University Press

Persson T and Tabellini G (2000) Political Economics: Explaining Economic Policy. Cambridge, MA: MIT Press.

Tiebout C (1956) A pure theory of local expenditures. The Journal of Political Economy 64(5):416-24.