The aim of this research project is to examine whether the fiscal equalization system is asuitable instrument for eliminating allocative distortions arising from tax competition. For thispurpose the role of fiscal equalization will be analyzed, both empirically and theoretically,focusing on German municipalities. The theoretical analysis examines how an optimal fiscalequalization system has to be shaped in order to account for regional heterogeneity ofpreferences and technologies.Furthermore, the research project aims at determining which modifications have to be carriedout if there exists a higher-level government, which accesses the same tax base and may ormay not be part of the federal system. These theoretical considerations lead to an empiricalanalysis of the effects of fiscal equalization transfers on local fiscal policy. On the basis of anextensive panel dataset, containing the municipalities of Baden-Wuerttemberg, an empiricaltest is carried out in order to find out whether the theoretically presumed effect of capacitybasedfiscal equalization can be approved.A further objective of the research project is to investigate whether the local fiscalequalization system is suitable for reducing the inefficiencies caused by fiscal and taxcompetition or whether alternative purposes can explain the design of fiscal equalizationamong municipalities in a better way.