Abstract: In a federation featuring decentralized leadership, regional governments compete by setting capital taxes in anticipation of the central government's fiscal-equalization and income-redistribution policies. As a benchmark, it is first demonstrated that the constrained socially optimal allocation satisfies the Pareto efficient conditions; therefore, it may be first best. It is also shown that the subgame perfect equilibrium for the decentralized leadership game is socially optimal. The anticipation of equalization of marginal utilities of public consumption and equalization of marginal utilities of private consumption provides regional governments with correct incentives in the setting of capital taxes.
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