2015/28: Market structure, the functional form of demand and the sensitivity of the vertical reaction function
Tax incidence and tax competition have largely been studied separately. Models assessing the incidence of excise taxes do not consider strategic interaction and exclusively assess the pass-through of taxes to prices. These settings focus on imperfectly competitive markets where prices can react more (less) than proportionally to a variation in tax rates. On the other hand, tax competition models focus on the strategic interactions arising because of a shared tax base but assume producer prices to be constant. Hence, the pass-through of taxes is restricted to be fully on consumers. This paper extends Keen (1997) by relaxing this assumption and, thus, by allowing local governments to internalize the possibility that taxes are over-shifted (undershifted). Interestingly, market structure (that was absent in previous settings), turns out to be one of the determinants of the vertical reaction function in this model; particularly determining the sensitivity of local tax setters to a variation of higher-tier taxes.