Vertical Externalities Revisited: New Results with Public Inputs and Unit Taxation

This paper studies the provision of public inputs in a federal system. We use a model with vertical tax and expenditure externalities to analyze the efficiency of equilibria under different settings, particularly Nash and Stackelberg equilibria. Our results discuss some findings from the previous literature. First, both vertical externalities are interrelated each other. Second, the condition for production efficiency in the public sector becomes irrelevant to assess optimality. And third, the replication of the second-best outcome by the federal government with limited policy instruments crucially depends on the states' reaction function.