Vertical Capital Tax Reaction Functions: Evidence from Sub-National
Governments in France
September 26, 2003
Timothy J. Goodspeed
Hunter College – CUNY
Department of Economics
695 Park Avenue
New York, NY 10021
USA
Matthieu Leprince
CREREG (UMR CNRS 6585)
Faculté des sciences économiques de
l’université de Rennes 1
7 place Hoche
35 065 Rennes cedex
France
Telephone : 1 212 772 5434
tgoodspe@hunter.cuny.edu
Téléphone : 33 2 23 23 33 37
matthieu.leprince@univ-rennes1.fr
Abstract: This paper investigates the extent to which the municipal or commune
level of government in France interacts strategically with the département level in the
setting of the local business tax, the “taxe professionnelle.” This is the main local tax
revenue source in France giving rise to more than 50% of the total tax revenues for the
communes. We use a unique cross-sectional data set on the 850 French communes (all
those with population greater than 10,000) for 1995 to estimate the slope of the vertical
reaction function between communes and départements. We find a significant and
positive relationship between the commune business tax rate and the département
business tax rate. The implied elasticity suggests that a 10 percent increase in the
département business tax rate leads to a 2 percent increase in the commune tax rate. We
also find that social spending mandated by the central government increases municipal
business taxes. We obtained these estimates after controlling for tax base and other
budgetary differences between communes, régional or cultural differences common to
both départements and communes, and differences in total public spending in
départements and communes.
1
1. Introduction
Capital tax competition is an important issue with far-reaching policy
implications. The literature on multinational taxation has established the importance of
capital taxes for the worldwide location of capital (see e.g. Hines (1996) for a review).
Furthermore, Altshuler, Grubert, and Newlon (2001) find that U.S. multinationals were
more sensitive to foreign tax rates in 1992 than in 1984. A set of recent papers (see e.g.
Buettner (2003) for a recent paper using European data and the comprehensive review by
Brueckner, 2003) study horizontal capital tax competition within countries, that is how
governments at the same level interact with each other in the face of mobile capital.
Horizontal tax competition between countries has also recently been studied by
Devereux, Lockwood, and Redonao (2002). Altshuler and Goodspeed (2003) find that
European countries followed the lead of the United States in changing their capital tax
systems after the 1986 U.S. Tax Reform Act, but not before.
Capital tax competition between levels of government is also an important
phenomenon in a federation. Vertical tax competition between the central and lower
levels of government has been studied by Besley and Rosen (1998) for sales taxation in
the United States, Goodspeed (2000, 2002) for income taxes in OECD countries, Hayashi
and Boadway (2000) for capital taxes in Canada, and Esteller-Moré and Solé-Ollé (2001)
for income taxes in the United States. Interactions between different tiers of sub-national
governments (e.g. states and municipalities) have not been estimated. We add to the
literature that attempts to estimate fiscal reaction functions by estimating a capital tax
reaction function for local governments (communes) in France with respect to the higher-
2
tier but still sub-national département level of government. We also provide evidence on
the impact of mandated social spending on local business taxes.
While highly centralized in certain respects, France is a country with multiple
levels of government.
In addition to the central government, three other local
government levels are prominent. Listed from highest level to lowest, these are the
région, the département, and the commune. Our focus will be on the interaction between
the commune level and the département level, the two major sub-national spenders. The
commune level undertook 60 percent of sub-national spending while départements
undertook 30 percent in 1995, the year of our data.
The French local capital tax that we examine is the taxe professionnelle. This tax
is the major revenue source for lower levels of government in addition to transfers. The
base of the tax is determined through a formula that resembles the apportionment
formulas used by US states.1 The French case provides something of a clean test since,
unlike the US state case, the central government determines the weights of the factors
which are the same for all sub-national governments. The sub-national governments are
free to set the tax rate, however. Our results indicate a positive reaction function. When
the département lowers its tax rate on capital, the communal level of government also
lowers its tax rate. The magnitude of the change is relatively small, however. We
estimate an elasticity of approximately 0.2.
The remainder of the paper is organized as follows. Section 2 provides some
background concerning the French business tax that we study. Section 3 develops the
empirical model. Section 4 presents the results and Section 5 concludes.
1
Weiner (1994) investigates capital’s movements resulting from the formula apportionment taxations of
capital by U.S. states.
3
2.
Background on French Sub-national Governments and Business Tax (Taxe
Professionnelle)
The local public sector in continental France is multi-tiered with three levels of
government: the municipal level (with communes or cities), the intermediate level with
94 départements and the higher level of 21 régions. There are more than 36 500
municipalities, but half the 60 million population lives in the 850 municipalities of more
than 10 000 inhabitants.
Communes (or municipalities) are responsible for urban planning, provide the
main local public services (water, sewage, sanitation, public transport), finance the
capital spending of nursery and primary schools, sports facilities and different public
amenities. Départements provide social services to children, disabled and aged people,
and training programs to unemployed people. They are also responsible for capital
spending for elementary schools (collèges) and roads. Finally, départements provide
some capital and economic development grants to municipalities. Régions provide
régional
planning,
development
amenities,
ongoing
vocational
training
and
apprenticeship, and finance the capital spending of high schools (lycées). Régions also
provide some capital and economic development grants to municipalities and
départements (but the amount of régional grants is much lower than that provided by
départements to municipalities).
Broadly speaking, the division of responsibilities between the three levels of
government doesn’t vary across départements or régions. However, variation can result
4
from differences in population density. In rural areas, very small municipalities tend to
allow the département to be responsible for some basic local public services that exhibit
economies of scale (municipal roads, public transportation, economic development
services) whereas in urban areas with the major municipalities (the sub-group whose tax
rate is our dependent variable), the scope of départemental responsibilities remains much
more in accordance to the usual division.
As previously mentioned, the municipalities represent about 60% of total
spending in the local public sector, départements 30% and régions 10%. Whatever the
level of local government one considers, spending is roughly covered by three main
revenue sources: local taxes (50%), grants from central or local governments (30%) and
debt (10%).
The major tax revenue source at both the commune and département levels is a
business tax called the taxe professionnelle (hereafter TP). The base of this tax is
determined by the central government according to a formula. In 1995 a business base
included 18% of employee wages paid by the company in the jurisdiction, 100% of the
value of the land in the jurisdiction used by the company in production, and 16% of the
historical cost of a company’s equipment used in the jurisdiction.
Each level of
government sets its own tax rate on this common base.
The remaining fiscal revenues are mainly collected from households and come
from a housing tax (the taxe d’habitation, TH), a property tax (the taxe foncière sur le
bâti, TFB) and a land tax (the taxe foncière sur le foncier non bâti, TFNB). Sub-national
governments’ ability to change the business tax rate is limited by a legal requirement: the
rate of the business tax may not vary more rapidly than the rates of taxes borne by
5
households. The shares of revenues from the four taxes for all levels combined are 50%
for the TP, 22% for the TH, 25% for the TFB, and 3% for the TFNB. The mean
cumulated TP rate in 1995 is 22.3% (14% communes ; 6.5% départements ; 1.8%
régions).
3. Econometric Model
The main purpose of the econometric model is to estimate the reaction of the
commune level capital tax to a change in the département level capital tax. One might
think of the underlying game between the commune and département in different ways.
The communes might play Nash with respect to the département and move
simultaneously. Alternatively, one might think of the département moving first as a
Stackelberg leader with the communes following. We estimate the reaction function
under both assumptions.
Our basic econometric estimating equation is:
C
D
ln tTP
= b0 + β ln tTP
+ ∑ γ ln R C + ∑θ ln S C + ∑η ln E D + ∑ µ ln D C +∑ν ln D R + ε
where tCTP and tDTP are the commune and département taxe professionnelle rates,
respectively, and the control variables include other revenue sources and expenditures of
the communes, RC, socio-economic characteristics of the communes, SC, expenditures by
the départements, ED, a set of dummies for certain geographic and institutional
characteristics of the communes, DC, and a set of régional government dummies, DR.
6
Sub-national data is not normally published by the French government and
consequently is hard to come by. Our data set combines three data sets on sub-national
governments. The first is a 1995 cross-section of the budgets of the 850 municipalities
(communes) with population greater than 10,000. We also have socio-economic data on
this level of government. This data is merged with a second data set at the département
level and a third data set at the régional level.
The dependent variable is the communal tax rate.2 While some of the control
variables are fairly standard others are somewhat particular to the case of France. We
discuss below the control variables.
We discuss and control for certain unique
circumstances in France that could explain a correlation between the department tax rate
and the commune tax rate.
The commune budget constraint suggests including the commune spending and
revenue variables. We include total spending, grant revenues, and revenues from three
tax sources: the property tax, a land tax, and a household tax. These three taxes may have
a particularly peculiar impact on the taxe professionnelle rate which does not have to do
with tax competition. The household tax (taxe d’habitation, TH) for instance, is a tax on
the resident of a dwelling (be it the owner or renter) and is based on the value of the
property in 1970.
The conventional wisdom in France is that the value was
underestimated in the South. Consequently, commune and département TH rates in these
areas, and hence commune and département TP rates, will tend to be higher. A similar
problem exists with the other tax bases. The inclusion of the revenues from these three
2
To take account of the effect of intercommunal groupings (certain services are shared in
metropolitan areas), the dependent variable is measured as the sum of the municipal tax
rate and, if it exits, the additional intercommunal rate.
7
tax sources on the right hand side helps to control for any artificially positive impact on
the TP rate due to an artificially low tax base at both the commune and département
levels.
We also include certain fairly standard socio-economic and geographic dummy
variables.
These include communal population, a dummy for a center-city in the
commune, a tourism dummy, a mountain dummy, and a variable reflecting the number of
second homes in the commune. These variables represent factors that might influence
costs or numbers of users of public services in, for instance, urban versus rural areas, and
hence the communal tax rate. Per-capita income is also included to capture demand for
public services.
Additionally, we include dummies for the 21 régions in continental France to
account for any systematic differences between régions. This could partially control for
low TH bases in the south, but also is intended to control for other régional differences
such as the higher reliance on private schools in the north and on public schools in the
south, or simply régional differences in preferences.
A second possible reason other than tax competition for a correlation between the
départemental and communal tax rates is that communes are mandated to give some
grants to départements for social spending. The total amount of such communal grants
received by a département is called the contingent communal d’aide sociale, hereafter
CCAS. The more grants a commune is required to give, the higher would be the
communal tax rate. To control for this, we include the level of CCAS grants (for the year
1997).3
3
Other grants (capital grants) go from départements to communes, but we have no data to
control for this. These grants mostly go to small communes that are not in our sample.
8
A third possible reason other than tax competition for a correlation between the
départemental and communal tax rates is that the tax base at one level is positively
correlated with the tax base at the other level. Hence, one might estimate a correlation in
tax rates that is due to tax base correlation. To control for this, we include the communal
TP base.
Finally, départements may have high tax rates simply due to high département
preferences or there may be complementarity or substitutability between départemental
and communal public services. To control for this possibility, we include départemental
spending variables in one specification.
An important econometric issue arises in the estimation of equation (1). Under
the assumption of Nash behavior between the commune and département levels of
government, the département tax rate on the right hand side would clearly be
endogenous. To obtain consistent estimates we instrument for the département tax rate
under the Nash assumption.
Under the assumption of Stackelberg behavior, the
département level of government would move first and the département tax rate would be
exogenous for the commune. Under this assumption we use the 1990 département tax
rate to estimate the 1995 reaction on the part of the commune.
4. Results
The results are presented in Table 1.
The first two columns assume Nash
competition between the commune and département levels of government while the last
column assumes Stackelberg behavior. Under the Nash assumption, we use a predicted
9
value for the concurrent département tax rate since it is clearly endogenous.
Our
instruments include all the exogenous variables of the model as well as certain
départemental and régional characteristics.
Under the Stackelberg assumption, the
commune decision comes after the département decision and we use the five-year lag for
the value of the département tax rate.
The key variable of interest is the département tax rate.
It is positive and
significant across all three specifications and the point estimate is relatively stable. The
implied elasticity evaluated at the means of the sample is approximately 0.2.
Several of the control variables are related to the government budget constraint.
The municipal tax base is negative and highly significant. Holding other revenue sources
and spending constant, the government budget constraint implies that municipalities with
higher tax bases will have lower tax rates.
Block grants are negative and highly
significant while government spending is positive and highly significant. Again, the
government budget constraint implies that holding other revenue sources and spending
constant, higher grants will lead to lower tax rates. Similarly, higher spending leads to
higher tax rates holding other revenue sources constant.
Social spending by and large is mandated by the central government and is jointly
administered by the département and municipal levels. This could lead to a positive
correlation between département and municipal tax rates that is not related to tax
competition. We control for this in two ways. In the first column, we include the total
municipal grants that help financing départemental social spending. While positive, this
coefficient is insignificant. In the second column we include départemental spending
variables.
The coefficient on social spending is positive and significant.
10
Hence,
departments that have high social spending may receive higher grants from communes,
inducing high commune business tax rates. While this reduces slightly the coefficient
and statistical significance of the département tax rate, it remains highly significant.
5. Conclusion
This paper investigates the extent to which the commune level interact
strategically with the département level by using a cross-sectional data set on the 850
French communes (all those with population greater than 10,000) for 1995 to estimate the
slope of the vertical reaction function between communes and départements.
Data
consists mainly on data on rates and bases for the local business tax, the so-called “taxe
professionnelle”, that is the main local tax revenue source in France with more than 50%
of the total tax revenues for the communes.
We find a significant and positive relationship between the commune business tax
rate (the main revenue source) and the département business tax rate. The implied
elasticity suggests that a 10 percent increase in the département business tax rate leads to
a 2 percent increase in the commune tax rate. We obtained this estimate after controlling
for several other possible explanations including mandated central government spending
in social spending, tax base differences between communes or other régional or cultural
differences common to both départements and communes, and different preferences for
public spending between départements and communes.
The results indicate a significant vertical interaction between municipal and
département business tax rates in France. Moreover, the results are of great significance
11
in the current French political context as France is at the eve of a new devolution process.
The central government is currently considering devolving new tax and spending powers
to local jurisdictions starting in 2005.
12
Table 1
Estimates for Nash and Stackelberg Assumptions
Dependent variable: Municipal Business Tax (TP) Rate
constant
Départemental TP rate
municipal TP base
TH housing tax revenues
FB property tax revenues
FNB land tax revenues
Block grants
Total spending
Income
Tourism dummy
Center city dummy
Mountain dummy
Nbr of second homes
Population
Nash-1
1.208**
(4.35)
0.202**
(4.50)
-0.286**
(-12.86)
0.009
(0.35)
0.039
(1.24)
-0.002
(-0.34)
-0.205**
(-4.61)
0.737**
(11.27)
-0.329**
(-6.44)
-0.013
(-1.32)
-0.002
(-0.23)
-0.002
(-0.22)
-0.042**
(-4.65)
0.051**
(3.28)
Départemental roads spending
Départemental social aid spending
Nash-2
0.964**
(3.29)
0.189**
(3.89)
-0.282**
(-12.59)
0.011
(0.42)
0.039
(1.26)
0.002
(0.28)
-0.194**
(-4.27)
0.732**
(11.14)
-0.319**
(-6.48)
-0.013
(-1.38)
0.002
(0.26)
0.005
(0.44)
-0.039**
(-4.40)
0.044**
(2.82)
-0.0155
(-0.91)
0.160**
(2.89)
-0.013
(0.45)
-0.073**
(-3.07)
Stackelberg
1.193**
(5.01)
0.238**
(5.98)
-0.283**
(-17.36)
0.010
(0.43)
0.033
(1.24)
-0.002
(-0.38)
-0.197**
(-5.03)
0.733**
(13.99)
-0.321**
(-8.01)
-0.014
(-1.36)
-0.004
(-0.45)
-0.005
(-0.38)
-0.042**
(-5.02)
0.053**
(3.61)
Départemental secondary schools
spending
Départemental economic
development spending
1997 Communal grants for
départemental social spending
Intercommunal dummies
Régional dummies
0.03
(1.27)
Yes
Yes
Yes
Yes
Yes
Yes
R2
N
0.6240
847
0.6281
847
0.6243
847
Notes: T-statistics in parentheses. Instruments of the TP départemental rate are the exogenous variables of the model and the
following départemental variables: TP départemental base, TH revenues, grants, surface, population. Intercommunal dummies
control for variation in the vertical allocation of responsibilities in the municipal and intercommunal block. We exclude Paris and
Corsican communes (Ajaccio and Bastia) from the sample.
13
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