Unemployment, Fiscal Competition, and the Composition of Public Expenditure

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This paper investigates the efficiency of equilibrium policies and public expenditure composition under labor market imperfection in a fiscal competition model. The sources of the inefficiency in supplying public goods and inputs with a capital tax are the employment stimulus and fund-raising effects of public inputs and fiscal and employment externalities. Public goods and public inputs are provided optimally if public expenditures are financed by capital and lump-sum taxes. However, if the capital tax is solely available, then public goods and public inputs can be either undersupplied or oversupplied in the second-best sense because jurisdictional governments seek to attract capital and create employment and tax revenues. Hence, in contrast to reports of the earlier literature on fiscal competition, an increase in public input expenditure financed by a decrease in public goods expenditure improves social welfare, depending on the inefficiencies of public goods and public input supplies.