Swiss cantons still compete for taxpayers
Fiscal equalization does not compensate for all differences among cantons.
BY LARS P. FELD
Tin
Switzerland has surprising news for its critics: 
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of the usual slowness in political reform, Swiss federalism has recently undergone significant changes in a short time. To bring the different income taxes for each canton more
in line with one another, a federal law on cantonal tax
harmonization was enacted in 1993 that gave the cantons until 2001 to adapt their income and profit tax bases to
certain minimum standards. Despite a wide interpretation by the Swiss federal (supreme) court, the tax harmonization
law did not aim at complete tax harmonization, as tax rates and large parts of tax bases have remained cantonal responsibility.
Swiss francs pays cantonal and local
in Zurich with a taxable income of a cannot getextra transfer
In a referendum in 2004, Swiss citizens accepted a packageof reforms of the fiscal equalization system. The old system had almost exclusively involved transfers from the confederation to the cantons and municipalities – what economists call “vertical transfers,” or transfers of funds from the central authority to the constituent units. Up to now, the cantons got 30 percent of the federal income tax as unconditional grants, and received additional matchinggrants. The unconditional grants comprised about a quarterand the conditional (matching) grants the other three quarters of total transfers to the cantons. Moreover, the cantons contributed to the federal social security schemes. All in all, total transfers amounted to about 15.5 billion Swiss Francs (about $12.425 billion U.S. dollars).
But beginning in 2008, these transfers, which were for the most part paid as matching grants, will be replaced by a new system combining both vertical and horizontal 
(transfer payments among entities of the same order), and based on unconditional grants. The new transfer systemwill consist of a so-called resource equalization scheme and a plan to equalize particular cantonal burdens. The federal government will contribute the funds for the equalization of specific burdens with a sum of 688 million Swiss francs per year. These transfers are paid to compensate for the burdens associated with living in mountainous and urban areas.
Not compensating for everything
The resource equalization scheme is funded by the federal government with about 1.8 billion Swiss Francs (about$1.44 billion U.S.) and the eight resource rich cantons with about 1.3 billion Swiss Francs (about $1.12 billion U.S).This money is distributed to the 18 resource poor cantons according to their position on a resource index that is derived from their aggregated (income and wealth) tax bases.
Professor Lars Feld is the Chair of Public Economics at the Alfred Weber Institute of Economics at the University of Heidelber
taxes of 25.1 per cent. One hour away
payments
Wollerau, in the canton of Zug, that person
simply because
pay only 7.9 per 
it chooses to
keep its tax rates below those of other cantons. The reform packagealso contains a new assignment of tasks to the cantons and the federal level. However, what could amount to more than half of today’s matching grants to the cantons will not be replaced by unconditional grants, but abolished as the federal government will take over the corresponding responsibilities and assume the cost of this expenditure. The new fiscal equalization system is also being created in order to compensate for the effects of tax competition between the cantons.
As if this was not enough, the Swiss Social Democrats announced in late 2006 a popular initiative calling for a referendum on their proposal to essentially harmonize cantonal taxes with fully harmonized tax bases as well as minimum tax rates. The initiative awaits its official launch,which requires the collection of a legally specified number of signatures to hold a referendum. As this initiative has gained additional attention after several cantons have recently introduced regressive income tax schedules,observers expect the Social Democrats to aim at using this political momentum to increase their voting share in the federal parliamentary elections in 2007.
Those not familiar with Swiss federalism might raise their eyebrows and wonder what is going on. Swiss citizens will have to ask themselves whether tax competition is sufficiently important to cause such political turmoil, and whether tax competition really affects their well-being.
The Swiss fiscal constitution
The Swiss fiscal constitution is unique among the classical federations as it results in a stronger decentralization of direct taxes than in any other federation. While the Canadian provinces or the U.S. states rely to a considerable extent on indirect taxes, the Swiss cantons have the basic
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a strong incentive to move to cantons with relatively lower tax burdens – if other attractions are the same.
Similar differences are found in the area of profit taxation, and as before they are largerat the local level than at the cantonal level. In this case, however, taxation is becoming more differentiated, with specific tax provisions. For example, tax holidays are offered for newlyfounded firms or holding privileges, special agreements for division of a company’s taxes among the cantons and so on. In many Swiss cantons, “holding privileges” give companiesexemption from income taxes if either two thirds of the company‘s income is derived from dividends or two-thirds of its assets consist of participations in other companies and the company does not engage in active business in Switzerland. Moreover, fiscal equalizationpayments cover between 12 per cent (Geneva)and 51 per cent (Jura) of total cantonal revenue. Three-quarters of these transfers are in the form of matching grants. The relatively small horizontal component of the fiscal equalizationsystem (between entities of the same order)involves direct compensation of spillovers -that is, the effects on other cantons of an action by a neighbouring canton.
Is tax competition really taking place today?
The supposed impact of tax differences in
residence or location choices can only be expected if other factors influencing these choices are the same in different regions. This is, however, not necessarilythe case in the real world. It is thus fair to ask whether tax differences really matter that much in Switzerland, givenother factors related to the attractiveness of each location. Empirical studies lend support for the varying impactof taxes on residence or location choices. The higher the income tax rates, the lower the number of taxpayers with high income in a canton. This phenomenon is especially pronounced at the highest end of the income distribution spectrum. As well, young, highly educated people react relatively strongly to tax-rate differentials. The effect of taxes also is more pronounced for self-employed taxpayersthan for employees or retirees. As well, it is stronger at the local level than at that of the canton. Public services partlycompensate for the impact of taxes, but there remains a noteworthy net impact. Income and profit taxes also affect
There are several factors that weaken the effects of interregional tax competition. On the one hand, tax levels are reflected in housing prices. The lower taxes are, the higher housing prices are. Thus, people moving from Zurich to Wollerau for tax purposes pay relatively highprices for their apartments. However, the reflection of tax differences in housing prices is incomplete, leaving room for tax competition to have an effect. On the other hand,vertical fiscal externalities exist that counteract horizontal fiscal externalities. Horizontal fiscal externalities might occur when cantonal governments reduce tax rates to attract taxpayers inducing taxes to be inefficiently low overall. However taxes tend to be inef
if different
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orders of government tax the same base, and this vertical fiscal externality offsets the tax reduction by some cantonal governments. The picture is completed by evidence of strategictax setting by cantons and local jurisdictions.They, indeed, set their tax rates to attract desirable taxpayers, although other factors also affect their choices. Thus, the bottom line is that tax competition exists in Switzerland,but it is not as fierce as the tax rate differentials suggest.
Where does tax competition lead?
Given that tax competition exists in Switzerland, does it have the effects that most proponents of tax harmonization fear? Empirical studies of the efficiency of tax competition in Switzerland largely indicate that tax competition enhances efficiency rather than reducing it. First, regional spillovers are less important than is often thought, or they balance each other out. In addition, the horizontal components of fiscal equalizationinternalize regional spillovers – that is,negative effects of one canton’s policies on a neighbouring canton. Second, tax competitionleads to lower spending and revenue in the cantons because there is lower tax revenue. Third, tax competition likewise shifts the revenue structure toward a greater use of fees and user charges. (However, larger user fees contribute to an increased inequality of aftertax income.) Fourth, it leads to higher overall labour productivity in the cantons, indicatinghigher efficiency as the cantons are forced to use their scarce resources at the lowest cost and according to citizens’ preferences. However, tax competition also restricts the ability of cantons to redistribute income through broadbased tax-transfer programs, although cantons and local jurisdictions do conduct income redistribution nevertheless. Thus the federal level, with its system of social security and the highly progressive federal income tax, is more important for income redistribution.
A balanced approach
Tax competition between the Swiss cantons and local jurisdictions is thus a very importantphenomenon. Given the empirical evidence,however, there are not strong grounds to justify a major tax harmonization at the moment. The Swiss fiscal constitution appearsto be well-adapted to the advantages and disadvantages of its competitive federalism. In particular, the federal income tax system plays an important role as regulator of cantonal tax competition and is, thus, able to serve demands for individual equality. The new fiscal equalization system is supposed to lead to a fairer regional distribution of income. Further measures restricting cantonal fiscal competition will only increase inefficiency in 
the public sector.
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-thy-neighbour” or “race-to-the-bottom” fiscal policies
the mobility of goods and factors of production have 
to undermine gains from decentralized decision-making, 
in Brazil, India, Mexico and Spain indicate. The 
U.S. federal systems have, on the other hand, successfully
by securing a common economic union.
Incentives for responsive governance
countries, especially in the developing world,
transfers are focused on dividing the pie without 
incentives for responsive and accountable service 
arrangements often discourage local taxation 
oduce perverse fiscal incentives through gap-filling 
transfers in most federal countries are focused 
ols and micromanagement, thereby undermining local 
a few countries such as the United States, they serve as a 
el politics. The practice of output-based transfers with 
standards and access to public services but having flexible 
programs and in spending allocations to create 
results-based accountability is virtually non-existent. A 
is the Canadian Health Transfers (CHT) program by
The principal conditions of the CHT program 
of access to health care and portability of health 
oss provinces.
The ability to adapt
have shown a remarkable ability to adapt and to meet 
in fiscal federalism. While the challenges they face 
similar, the solutions they discover and adopt are always
This represents a remarkable attestation to the triumph
federalism in its never-ending quest for balance and 
responsive, responsible and accountable governance. The 
attain new heights in inclusive governance continues.
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