ECONOMIC RESEARCH CENTERDISCUSSION PAPER
E-Series

No.E15-5

Municipal Merger and Tax CompetitionbyHikaru Ogawa
Taiki Susa

July 2015

ECONOMIC RESEARCH CENTERGRADUATE SCHOOL OF ECONOMICSNAGOYA UNIVERSITYMunicipal Merger and Tax Competition∗
Hikaru Ogawa†Taiki Susa‡

Nagoya University

Chubu University

Abstract
This paper integrates the models of municipal consolidation and fiscal
competition to examine governments’ incentives for merging municipalities when countries engage in global tax competition. The result showsthat the prospective tax competition leads to excessive municipal mergers.

Keywords: tax competition, municipal merger.
JEL Classification Number: H73, H77, P48∗ The research has been supported by grants from the Japan Society for the Promotion of
Science (25245042 and 15H03366).
† Graduate School of Economics, Nagoya University, Furocho, Chikusaku, Nagoya 4648601,
Japan. Email. ogawa@soec.nagoya-u.ac.jp, TEL.+81-52-789-2379. FAX. +81-52-789-4924.
‡ College of Business Administration and Information Science, Chubu University, 1200
Matsumoto-cho, Kasugai-shi, 487-8501, Japan. Email. susa@isc.chubu.ac.jp, TEL. +81-56851-9344.

1

1Introduction

Nowadays, economic studies no longer consider jurisdictional borders as exogenously given. Following the pioneering work of Buchanan and Faith (1987), a
series of studies by Bolton and Roland (1996, 1997) and Alesina and Spolaore(1997, 2005, 2006) adopted an innovative approach to study the endogenous
determination of borders between nations. The key factor that aﬀects the creation of national borders is the trade-oﬀ between heterogeneity in preferences
and scale economies in providing public goods. Others focus on the borders atcity and municipal levels in a country. Ellingsen (1998) models the trade-oﬀ
between inter-regional externalities and heterogeneity in determining the designof jurisdictions. Dur and Staal (2008) presented a model to study public goods
provision with spillovers, endogenous formation of municipalities, and the eﬀects
of transfers from higher-level governments. The most recent study of Breuille
and Zanaj (2013) examine the impact of the regional merger on the tax rates ofa two-tier territorial governments.
This paper shares the interests on the design of municipal borders with thelatter and aims to provide further insight into the endogenous determination ofmunicipal borders when countries face market integration in a global economy.
To capture the eﬀect of globalization, openness to trade has been incorporated in
the analyses of (dis)integration (Alesina, Spolaore, and Wacziarg, 2000; Casella
and Feinstein, 2002; Etro, 2006). In this paper, we use an alternative and moreelaborate strategy to deal with the eﬀect of globalization on mergers. Whilemost of the models deﬁne openness to trade in an ad hoc manner by pushingaside the production sector, this paper incorporates more realistic production
activities into the model, focusing on the interregional mobility of production
factors. For this purpose, in this paper, we integrate the municipal merger
model with the canonical model of tax competition, and the paper explicitly
deals with production, capital mobility, and distorting taxation.1 Integrationof the two approaches is quite natural, and is useful for analyzing the eﬀects ofglobalization on the design of domestic jurisdictions.
So far, two studies have analyzed the formation of jurisdictions under tax
competition. The ﬁrst, by Perroni and Scharf (2001), presents a highly sophisticated model and examines the eﬀects of tax competition on the taxationlevel selected through majority voting within jurisdictions and the jurisdictionalboundaries. It shows that a downward pressure on taxation associated with tax
competition reduces the gap between the median voter’s choice and the taxationlevel preferred by peripheral residents, which makes it more acceptable to bea resident in a larger jurisdiction than one in a peripheral location. The mainargument is fairly close to ours, but the mechanism used is diﬀerent. In ourmodel, the borders of municipalities are determined by the central governmentof the country, so they choose a large jurisdiction in advance in order to prevent prospective tax-cutting competition. The second study, by Leite-Monteiro
1 Studies on tax competition have a long history, at least since the established works of
Gordon and Wilson (1986), Zodrow and Mieszkowski (1986), and Wilson (1986). See Wilson(1999) and Wildasin and Wilson (2004) for extensive reviews of tax competition models.

2and Sato (2003), also discusses political (dis)integration using the tax competition model. However, the intended jurisdiction in our paper diﬀers considerablyfrom their analysis. While they follow mainstream analyses and examine the(dis)integration of a sovereign nation, our interest is with the endogenous determination of municipal borders within the country, and what we intend to argue
is that countries have an incentive to promote consolidation or separation ofmunicipalities and therefore change the number of municipalities in preparation
for prospective tax competition.
Our interest on the borders of municipalities stems from the widely observed
fact that while many countries have promoted the consolidation of municipalities, thereby drastically decreasing the number of municipalities, other countries
have not taken such consolidation measures. Although care should be exercisedwhen comparing the diﬀerent deﬁnitions of municipalities among the countries,
it leaves no doubt that, regardless of the type of sovereign state and size of country, most countries reduce the number of municipalities, while a few countries
keep their municipal borders fairly stable.2 The integration and consolidationof jurisdictions observed at the municipal level in many countries is quite incontrast to the disintegration and division of nations at the state level, observedin the same period of time.3
In the context of the conventional tax competition model based on endogenous determination of municipal borders, we show that a benevolent government, intending to maximize national welfare, has incentives to change thenumber of municipalities within a country when it faces the capital market integration. Speciﬁcally, we show that the critical externality which is involved by
the choice of municipal borders leaves the size of municipality too large: Whencountry i increases the size, and thereby decreases the number of jurisdiction,
it avails of scale economy caused by promoting diversity in labor inputs. This
makes capital investment attractive, and thus it induces capital inﬂow. This isa ﬁrst-order positive aspect of controlling the size (number) of jurisdiction ina country. However, the ﬁrst-order eﬀect is fraught with standard ﬁscal externality; municipal mergers in country i attracts capital from abroad and reduces
the tax base in country j, and that reduces the tax revenue in country j. The
government in country i does not take into account this negative eﬀect on the
tax revenue of other countries and therefore tends to promote the excessive
municipal mergers. On the other hand, the choice of size (number) of municipalities in a country has second-order eﬀects. An increase in investment return
accompanied by the increase in the size of municipality in country i puts thebrakes to tax-cut incentive in country i, and accelerates the drive for cutting
its tax rate in country j. This induces capital outﬂow from country i. The
2 The number of municipalities in Denmark, England, Japan, Korea, Sweden, Belgium, andGermany has decreased, at least, by 50% or more over the last 50 years. Other countries,
such as Finland, Norway, Netherlands, Spain, and Austria have also reduced the numberof municipalities to significant degree. Contrastingly, some countries, such as France, Italy,
Swiss, and Portugal, have kept their municipal borders stable, and the United States has
exceptionally increased the number of municipalities due to the creation of school district.
3 For instance, the number of countries in the United Nations was 60 in 1950, which wasboosted to 154 in 1980 and 192 in 2010.

3

capital outﬂow from country i increases the tax bases and thus tax revenues ofother countries. In this way, an increase in the size, and thereby a decrease in
the number of jurisdiction positively aﬀects the tax revenues of other countries
through changing the tax rate in the tax competition stage. Since country idoes not account for this second-order positive impacts on other countries ofdecrease in the number of jurisdiction, it sets the number of jurisdiction toolarge, and thus chooses deﬁcient municipal merger. The change in the size ofmunicipality produces the ﬁrst-order negative and the second-order positive effect, but the former outweighs the latter, and thus the government promotes
excessive municipal mergers in the global market. This result suggests not onlya critical implication that countries ﬁnd themselves plunged into a prisoner’s
dilemma in choosing municipal borders and the number of municipalities but
also the eﬃcient segmentation of municipalities limited by global competitionin an integrated capital market.
This paper is organized as follows. Section 2 introduces the basic model andSection 3 presents the main results. Finally, Section 4 concludes the paper.

2

Model

Country. There are two symmetric countries in our model, denoted by i (i =W, E), and each country has a single central government. The population of eachcountry, normalized to 1, is immobile and uniformly distributed over the interval[0, 1]. The geographical distribution coincides with the ideological distribution,
indicating that geographical neighbors have similar preferences on the public
policy enforced. Symmetric local jurisdictions (municipalities) are a segmentof this interval. The (population) size of a local jurisdiction in country i isdenoted by si ∈ (0, 1], which indicates that the number of local jurisdictions isgiven by 1/si . Since the population varies by ideology, si also stands for thediversity in population in a jurisdiction. The smaller si , the larger the number ofmunicipalities and the smaller diversity in a jurisdiction in country i. The upper
limit of si = 1 corresponds to complete consolidation, where all individuals incountry i are forced to consume the uniform public good in a single municipality.
Local jurisdiction j of country i provides a public good that is solely ﬁnanced
by capital taxation. The public good is non-rival, but excludable in the sensethat an individual residing in jurisdiction j can beneﬁt from the public good
provided only in jurisdiction j.
Production. The production of private goods in a local jurisdiction requires
capital and labor. The capital is perfectly mobile among the jurisdictions andcountries. The total capital in this economy is assumed be ﬁxed at K. Absentee
capital ownership is assumed, so there is no capital return to the residents incountries, W and E.4 The population in each jurisdiction of country i is si , and4 This assumption, which is also advanced by Hindriks et al. (2008) and Kempf and RotaGraziosi (2010), is made just for simplification, so it is not crucial for our analysis of symmetricjurisdictions.

4all residents supply a unit of labor in the jurisdiction of residence. In this case,the amount of labor in the jurisdiction is given by si . We assume the production
function expressed as


Kji
Kji ,
Yji = Ai −siwhere Yji is the output level and Kji the amount of capital used for production in jurisdiction j of country i, and Ai ≡ a + si (a > 0). This formulation
assumes the scale economies in production associated with the labor diversity,and scale economies are modeled as arising through external increasing returns
to diversity.5 Taking notice that the ﬁrms face with the CRS technology when
they treat Ai as exogenous parameter, an increase in labor diversity in a jurisdiction has a productivity eﬀect on all ﬁrms in the jurisdiction even though eachcompetitive ﬁrm believes that it is operating under constant returns to scale.
Unlike ﬁrms, the government recognizes that a modiﬁcation in jurisdictionalboundaries changes in the jurisdiction’s diversity in labor inputs which impacts
on the ﬁrms’ productivity.
The production per capita can be represented byyji = f (κji ) = (Ai − κji )κji ,where κji ≡ Kji /si . A ﬁrm’s proﬁt in jurisdiction j of country i is given by
πji = (Ai − κji )κji − rκji − Tji κji − wji ,(1)

where r is the price of capital, Tji is the (unit) tax rate imposed on capital, andwji is the wage rate. The proﬁt maximization yields
r = Ai − 2κji − Tji .

(2)

Residents. Following Alesina and Spolaore (1997) and Etro (2006), a resident’s
preference in jurisdiction j of country i is assumed to be given byuji = cji + gji (λ − δlji ),(3)where cji denotes the consumption level of a private numeraire good, gji a public good, and lji is the preference distance from individuals in jurisdiction j ofcountry i to the jurisdictional government; δ > 0 reﬂects the cost of heterogeneity and λ > 0 denotes the native utility from public good consumption. Using(1) and (2), we have wji = κ2ji . Hence, the budget constraint of the resident
requirescji = κ2ji .

(4)

5 This approach is based on the concept of (Marshallian) external economies which has
been used frequently to explain scale economies of in production. See Chipman (1970) and
Abdel-Rahman and Fujita (1990), among others.

5Local Jurisdiction (Municipalities). To ﬁnance the public good, the jurisdiction
can use only unit tax on mobile capital. To avoid horizontal ﬁscal externality
due to wasteful tax competition between local jurisdictions in the country, thecentral government in country i controls the rate of tax and imposes a uniform(unit) tax rate for all jurisdictions in the country, Tji = Ti . Thus, from (2),κji = κi ∀j.

(5)

The budget constraint of jurisdiction j of country i is given by gji = Ti Kji .
Using κji ≡ Kji /si and (5), we can rewritten the budget constraint as
gji = Ti κi si .

(6)

Capital Allocation. All capital is allocated among two countries:
K = kW + kE ,(7)

where ki is the amount of capital located in country i. Note that the capital
1/s
1/s
located in country i is given by ki = Σj=1i Kji = Σj=1i κji si = κi since κji = κi .6
Hence, using (2) and (7), the capital located in country i is obtained as follows.
2K + si − sm + Tm − Ti
, m = i.
4
Given si , the tax eﬀects on capital allocation is given by
ki =

1
∂km
∂ki
=− =−
,
∂Ti
4
∂Ti

m = i.

(8)(9)

In a similar fachion, given Ti , the eﬀect of change in the si on capital allocation
is given by
1
∂km
∂ki
= =−
,
∂si
4
∂si

m = i.

(10)

From (2) and (8), the price of capital is given by r = a − K − 0.5(TE + TW −sE − sW ).

Central Government. Each central government expects the country’s choice on
the number of jurisdictions to aﬀect its capital allocation, at least in the long run,and so it has an incentive to control the size, and thereby the number of local
jurisdiction in its country. We assume that the central government in country i
1maximizes the sum of utilities in its country, Ui = 0 uji dj. Given the symmetryof jurisdictions in the country and the assumption of uniformity of distribution of
6 The amount of capital in jurisdiction j of country i, K , can be obtained by dividing kjiiwith the number of jurisdiction, 1/si as ki /(1/si ) = si ki .

6the country’s population, using (3) and (4), the central government i’s problem
is to maximize


δsi
(11)
+ ki2 ,
Ui = gi λ −4subject to (6) and (8).7 Substituting (6) into (11), the objective function canbe given by


δsi
2
Ui = Ti ki Ωi + ki , where Ωi ≡ si λ −.
(12)4At this stage, our approach to determine the tax levels and municipal borders
is slightly diﬀerent from the approach used in political (dis)integration models
developed by Alesina and Spolaore (1997). The political (dis)integration models assume that they are determined as the stable equilibrium in which theindividuals living within a jurisdictional border have no incentive to change
their decision through majority voting. Diﬀerent from this approach, we simply
assume that the size of local jurisdictions and tax rates within a country are
determined and enforced by the central government. This is, at least, partly
justiﬁable as the central government can promote mergers of local jurisdictions
indirectly through various policy instruments, such as grants and special tax
and debt treatments associated with the municipal mergers.
The central governments’ decisions are made in two stages. First, theydecide simultaneously and independently the size of a jurisdiction, and thereby
the number of local jurisdictions, (sW , sE ). Once sW and sE are observed, it is
not feasible to change the decision about si at this time. Thus, in the secondstage, given sW and sE , each central government simultaneously chooses its tax
rate on mobile capital: (TW , TE ). The reason why we model the process as a
two-stage game is that decisions about municipal mergers/secession are longrun in nature, and are taken as ﬁxed in the second stage. Tax rates, on thecontrary, could be changed more easily in the short-run.
The structure of a model has important strategic eﬀects on the number ofjurisdiction. It not only aﬀects the tax rate chosen by country i in the tax
competition stage, but also impacts the tax rate chosen by the other country.
Since the ﬁnal outcome of this game can be derived as the subgame perfectequilibrium, we solve it by backward induction.

7 Denoting the size of each municipality in country i by s , the sum of preference distance ofi
R0.5s
individuals who resides in any municipality is given by 2 0 i xdx = s2i /4. Since the numberof municipality in country i is 1/si , the sum of preference distance of individuals in country i
is given by si /4, which leads to (11).

7

3Equilibrium

3.1

Second Stage

Given the size of local jurisdictions, sW and sE , the central government ofcountry i chooses Ti to maximize (12). In choosing Ti , each government correctly
anticipates the tax eﬀects on capital allocation, which is given by (9). The
maximization problem yields


∂Ui
∂ki
∂ki
= ki + Ti= 0.
(13)Ωi + 2ki
∂Ti
∂Ti
∂Ti
Using (8) and (9), (13) yields the tax reaction function as Ti = Ti (Tm ; si , sm )(m = i):2Ωi − 1(2Ωi − 1) (2K − sm + si )Tm +,m = i.
(14)4Ωi − 14Ωi − 1
To ensure strategic complementarity in tax competition, we make the following
assumption, which ensures a unique and stable equilibrium in tax competition
stage.
Ti =Assumption 1. 2Ωi > 1.
Assumption 1 is likely to hold when λ/δ is suﬃciently high. Notice that∂Tm
|given Ti∂si∂Ti|given Tm∂si==2Ωm − 1< 0,
4Ωm − 12Ωi − 1 2 (2K + Tm − sm + si ) ∂Ωi.
+
4Ωi − 1∂si
(4Ωi − 1)2

−

(15)
(16)

(15) implies that the increase in si in the ﬁrst stage reduces the tax rate in othercountries in the second stage, given Ti . This is because the increase in the size ofmunicipality improves the productivity of capital through labor diversity eﬀects,
and thus the rival country has to reduce its tax rate to enhance the appeal ofinvestment environment. The ﬁrst term of (16) represents the positive eﬀect ofsi on the tax rate; if si is large, the productivity of capital becomes high, andthereby the government has no need to engage in tax-cutting competition andtends to choose higher tax rate. The sign of second term depends on the signof ∂ΩW /∂sW . If λ (beneﬁt from public goods) is high enough (a is low enough)to make the sign of ∂ΩW /∂sW positive, then the increase in si increases thetax rate. However, if λ (beneﬁt from public goods) is low enough (a is highenough) to make the sign of ∂ΩW /∂sW negative, then the increase in si is likely
to reduce the tax rate. Solving (14) for i = W, E, we obtain the tax rates as
Ti (si , sm ):Ti =2K (3Ωm − 1) (2Ωi − 1) Ωm (si − sm ) (2Ωi − 1)+.
6Ωm Ωi − Ωm − Ωi6Ωm Ωi − Ωm − Ωi8(17)

Furthermore, using (8) and (17), we get the amount of capital in country i as
ki (si , sm , Ti (si , sm ), Tm (si , sm )).

3.2

First StageIn the ﬁrst stage, the central government in country i chooses the size of its
local jurisdiction, si , by anticipating the direct eﬀect of si on the utility andthe strategic eﬀect through the tax choice decided in the second stage. Expressing the objective function as Ui = Ti ki Ωi (si ) + ki2 , where Ti (si , sm ) andki = ki (si , sm , Ti (si , sm ), Tm (si , sm )), the incentives for municipal merger are
given by the derivative
∂Ui
∂si

∂ki
∂ki ∂Tm∂Ωi= ki
Ti + (Ωi Ti + 2ki )+ (Ωi Ti + 2ki )∂s∂si∂Tm ∂si
 i


∂ki
∂ki ∂Ti= 0, m = i.
ki + TiΩi + 2ki∂Ti∂Ti ∂si(18)

The last element on the right-hand side is, from (13), equal to zero by theenvelope theorem. Hence, the ﬁrst three terms aﬀect the equilibrium level ofmunicipal merger.

3.3

Effects of Market Integration

We now study whether the government increases or decreases the number of municipalities when it face with the capital market integration. When the capital
market is not integrated, and thus capital does not move over the jurisdictions
and countries, ki = K/2. In this case, reminding that the last term in (18) iszero, we have∂Ui∂Ωi
= k i Ti
= 0,
∂si
∂si
since ∂ki /∂si = ∂ki /∂Tm = 0. Hence, the government chooses the size ofmunicipality in the closed market, sic , to satisfy
sic =

2λ
.
δ

(19)

(19) shows that the central government expands the size of each municipality
by promoting municipal merger as the public goods gain in importance, but it
is reluctant to municipal mergers as the heterogeneity in individual preferences
increases.
The size of municipality when the capital market is integrated is determinedby (18), in which the last term is again zero. Evaluating (18) at sic , we have∂ki∂ki ∂Tm∂Ui|sic = (Ωi Ti + 2ki )
+
.
(20)
∂si
∂si
∂Tm ∂si9

From (17), we have
∂Tm
∂si

=

2K (3Ωm − 1) (2Ωm − 1) − Ωm (sm − si ) (2Ωm − 1) ∂Ωi∂si(6Ωm Ωi − Ωm − Ωi )2−Ωi (2Ωm − 1).
6Ωm Ωi − Ωm − Ωi(21)

Using (9), (10), and (21) with ∂Ωi /∂si = 0 (since we evaluate at sic ), (20) is
rewritten asΩi Ti + K 4Ωm Ωi − Ωm∂Ui|sic =
> 0,
(22)
∂si
4
6Ωm Ωi − Ωm − Ωiin which the last inequality comes from Assumption 1. (22) suggests that the
government promotes municipal merger when it faces with the capital market
integration. Summarizing above discussion, we obtain the following result.
Proposition 1. Capital market integration leads municipal merger.
When the capital is ﬁxed its location, the government simply chooses the sizeof municipality to balance the marginal cost associated with the heterogeneityand marginal beneﬁt of non-rival public goods consumption. Once the market
is opened, and capital is free to move across the borders, the government has
an additional incentive to increase the size of municipality. By enlarging its
size, each municipality is able to utilize the economies of scale in production, sothat the capital inﬂow is promoted, which induces the government to promotemunicipal merger when the capital market is integrated.

4

Cooperative Outcome

We now refer to the cooperative policy choices in the integrated capital market.
The cooperative policy choices can be found by maximizing the sum of utilities
across the countries; V = UW + UE , where Ui is given by (12). With (8), thecooperative tax rate and the size of municipalities, Ti∗ and si∗ satisfy
∂V
∂Ti
∂V
∂si

∂km
∂ki
∂ki
) + 2ki+ (Tm Ωm + 2km )
= 0,
∂Ti
∂Ti
∂Ti
∂Ωi
∂ki
∂km
= Ti k i+ (Ti Ωi + 2ki )+ (Tm Ωm + 2km )
= 0.
∂si
∂si
∂si
= Ωi (ki + Ti

(23)
(24)

Comparing equilibrium conditions with the conditions for cooperative outcome,we have the following results.
Proposition 2. The equilibrium tax rate is lower than the cooperative tax ratein the tax competition stage.
10

Proof. From (13) and (23), We have∂Ui
∂km|Ti∗ = −(Tm Ωm + 2km )
< 0.
∂Ti
∂Ti

(25)

The last inequality comes from (9). (Q.E.D.)
Proposition 2 replicates the standard argument in tax competition theory.
(25) captures the conventional horizontal ﬁscal externality arising from the eﬀect
on tax revenues of capital movements between countries accompanied by thechange in the tax rate. The central government in country i has incentives toreduce its tax rate from the cooperative level, by which it can attract mobile
capital. However, the capital inﬂow into country i accompanied by a reduction
in Ti reduces the tax base in other country, km , and thus, aﬀects the othercountry’s ﬁscal budget as Tm (∂km /∂Ti ). The central governments ignore thisnegative external eﬀects of their reduction in reducing Ti on other jurisdictions.
The eﬃciency of municipal size (and the number of municipalities) is summarized as follows.
Proposition 3. The equilibrium size of municipality is larger than the sizeof municipality in the cooperative outcome. Conversely, the equilibrium
number of municipality is smaller than the number of municipality in thecooperative outcome.
Proof. From (18) and (24), we have∂Ui|s∂si i∗=(Ωi Ti + 2ki )∂ki ∂Tm∂km− (Ωm Tm + 2km ).
∂Tm ∂si∂si(26)

Substituting (9), (10), and (21) into (26), and evaluating at the symmetricequilibrium, we have∂Ui
(T Ω + k) (4Ω − 1)|si∗ => 0.
∂si8(3Ω − 1)(27)

The last inequality comes from Assumption 1. (Q.E.D.)The second term in (26) represents the ﬁscal externality associated withthe government choice on si . When the government i increases si , conversely,
decreases the number of municipalities, based on (10), it induces the capitalinﬂow into country i and capital outﬂow from country j. Government i does
not account for the negative eﬀects caused by an increase in si , and thus it tends
to promote excessive municipal mergers. This is the ﬁscal externality associatedwith the ﬁrst order eﬀects of the choice on si . Instead, the government accounts
for the second-order eﬀect of changing si on capital allocation, which is expressedin the ﬁrst element in (26). The sign of ∂ki /∂Tm > 0 is clear and is positive, but
11the sign of ∂Tm /∂si is ambiguous as shown in (24). Suppose that the increasein si reduces the equilibrium tax rate of country m, ∂Tm /∂si < 0. Then, theﬁrst and second element in (24) take opposite sign since ∂ki /∂Tm > 0. In
contrast, when ∂Tm /∂si > 0, then two terms take positive value and thus,
the government has incentive to increase the size of municipality from the sizethat should be achieved as the cooperative solution. Proof of proposition showsthat the ﬁrst-order negative eﬀects are greater than the second order eﬀects atthe symmetric equilibrium, implying that the government promotes excessive
municipal mergers.

5

Concluding Remarks

In this paper, we extend the model of regional (dis)integration in three directions: (i) the single-country framework is extended to the two-country model;(ii) the production sector is explicitly incorporated; and (iii) capital as a production factor is mobile among the countries. This extension is positioned as the integration of the two analyses of ﬁscal competition and regional (dis)integration.
Our ﬁrst result shows that once the capital market is integrated, each country
reduces the number of local jurisdiction. Our second result shows that ﬁscal
competition caused by capital market integration leads the size (number) of
jurisdiction in each country ineﬃcient level, and leads to excessive municipal
merger.
In concluding the paper, we point out some problems that remain unresolved.
First, all outcomes are derived under speciﬁc function. These certainly weaken
the generality of results. Second, we have only considered a case of capital
mobility: geographical locations and preferences are assumed to coincide, withno migration. While this is a feature of the models of political geography,
which diﬀerentiates the analyses from the model of economic geography with
migration, it can also be justiﬁed by using the concept of Tiebout sorting. Afterthe free choice of residential location, people who have similar preferences for
public services locate side-by-side. Once they choose the location, household
mobility may be relatively more diﬃcult than capital mobility. Hence, the model
can be interpreted as if it started from the stage that households have chosen
their location points. Owing to the assumption of no migration, this model canbe presented as a simple one-dimension model. To eliminate the coincidence ofgeographical and preference distribution, it should be reconstructed as a twodimension model, which is one of the remaining tasks.
Third, one can easily realize that multi-level governments are assigned with
diﬀerent types of public policies. Our model does not consider issues such as
variety of public good, intergovernmental transfers, congestion in public good
consumption, and beneﬁt spillovers. Overall, no substantial role is assigned tomunicipalities. Extensions to analyze ﬁscal devolution and equalization are certainly important and can be related to the models of ﬁscal federalism literature.
These issues are potential topics for future research.

12

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