Yardstick Competition in Local Business Taxation: Quasi-Experimental Evidence from Portugal

This paper exploits an exogenous reform in Portugal to study yardstick competition among local governments in setting the local business tax rate. The reform universalizes the local business tax rate to all municipalities, whereas previously this instrument was only available to local governments involved in financial stability pacts or in need of raising fiscal capacity. Relying on a difference-in differences (diff-in-diff) framework, this paper studies whether municipalities neighboring the ones that levied a local business tax already in the pre-reform period make a significantly different use of this new fiscal instrument vis-a-vis non-neighboring municipalities. Results show that neighboring municipalities are significantly more likely to levy the business tax rate in the aftermath of the reform. Tax rates levied in neighboring municipalities are also on average significantly higher and raise significantly more revenues. Evidence of significant treatment effects decreases over time and in particular after the first election under the new local finances reform. This paper shows that the mechanism behind these dynamics appears to be electoral results. In particular, local business taxation depends on the victory margin of the incumbent, but appears to have no impact on the probability of his/her re-election.