Evaluating Regional Tax Competition and the Role of Central Government in Brazil

This paper analyses if income tax policy of central government does matter for the equilibrium of regional tax competition in Brazil due its potential effects on fiscal budget of regional governments. An interregional CGE model calibrated for the Brazilian economy is used to evaluate an experimental tax competition game where regional governments use indirect tax rate as strategies to attract investments and expect to guarantee fiscal solvency by transfers from central government and central government adjusts its income tax policy as reaction of this tax competition game. The results show that Nash equilibrium is race-to-the-top and welfare improving because the optimum strategy of central government is to reduce the income tax rate. This forces regional governments to raise tax rate to achieve the fiscal solvency rule. The central government behavior works as a fiscal compensation for the households, but the welfare gain is a fiscal illusion because it is accomplished by reductions in GDP and employment at the equilibrium.

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