1 Vertical Capital Tax Reaction Functions: Evidence from Sub-National Governments in France September 26, 2003 Timothy J. Goodspeed Hunter College – CUNY Department of Economics 695 Park Avenue New York, NY 10021 USA Telephone : 1 212 772 5434 tgoodspe@hunter.cuny.edu Matthieu Leprince CREREG (UMR CNRS 6585) Faculté des sciences économiques de l’université de Rennes 1 7 place Hoche 35 065 Rennes cedex France Téléphone : 33 2 23 23 33 37 matthieu.leprince@univ-rennes1.fr Abstract: This paper investigates the extent to which the municipal or commune level of government in France interacts strategically with the département level in the setting of the local business tax, the “taxe professionnelle.” This is the main local tax revenue source in France giving rise to more than 50% of the total tax revenues for the communes. We use a unique cross-sectional data set on the 850 French communes (all those with population greater than 10,000) for 1995 to estimate the slope of the vertical reaction function between communes and départements. We find a significant and positive relationship between the commune business tax rate and the département business tax rate. The implied elasticity suggests that a 10 percent increase in the département business tax rate leads to a 2 percent increase in the commune tax rate. We also find that social spending mandated by the central government increases municipal business taxes. We obtained these estimates after controlling for tax base and other budgetary differences between communes, régional or cultural differences common to both départements and communes, and differences in total public spending in départements and communes.