Local Policy Effects in the Presence of Regional and Policy Spill-Overs

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Many important economic decisions have a regional component. Factors like local wages, the commuting distance, local transportation and a city's quality of life play a crucial role when individuals choose the location of their residence and their workplace. Many of these factors are in turn influenced by local policies, which are prominent in most countries that have a federal structure. In those countries, local governments set their own tax rates or decide on local infrastructure investments to make their city more attractive. In addition, many federal countries make use of region-specific subsidies financed by the central government, which also affect the relative attractiveness of a specific location. Previous studies have primarily focused on the direct effects of such local policies on the affected regions. However, it is well known that localities compete against each other and react strategically to policy choices of neighboring jurisdictions. As a result, it is likely that local policies implemented in or targeted at one specific region will indirectly affect other, allegedly uninvolved regions as well. Against this backdrop, the research objective of this project is to empirically test for such regional and political spill-overs of local policies on other regions. In order to do so, the German institutional setting is exploited, where more than 11,000 small municipalities which can independently make important fiscal decisions such as setting tax rates or increasing spending. A general precondition for regional spill-overs is that economic agents are mobile. The first part of the project will, therefore, investigate the mobility of individuals. Exploiting variation in municipal business tax rates that induces downward pressure on wage, the project will analyze how this wage pressure affects the locational decision of workers in terms of workplace, residence or both. In a second part, the effect of place-based policies are studies, which should trigger a different type of regional spill-overs as competing but initially unaffected regions should adjust their local policies as a response to not receiving the subsidy. This mechanism is tested using two German placed-base policies: (i) the Zonenrandgebietsförderung of West German municipalities close to the inner-German border in the 1980s; and (ii) the Gemeinschaftsaufgabe Verbesserung der regionalen Wirtschaftsstruktur (GRW) targeted at East Germany regions after reunification. Last, the project focuses on specific spill-overs effects induced by tax competition. The project intends to advance the tax competition literature by allowing governments to set two tax instruments - an assumption that holds for most local governments. The theoretical predictions are then tested using data on German municipalities, which can set both business and property tax rates.