Fiscal Capacity, Tax Effort, and Optimal Equalization Grants

Abstract

In this paper, we address the question: How should the tax burden in a feder- ation be distributed across the different jurisdictions so that the social cost of providing government services is minimized? Using optimal tax theory, we derive formulas for the optimal equalization grants that equalize the social marginal cost of raising revenue across all provinces. We show how the optimal equalization grants are related to a measure of tax effort based on the marginal cost of public funds and a measure of fiscal capacity that takes into account the elasticity of the tax base and its substitutability with other tax bases.