Tax compliance and fiscal externalities: Evidence from U.S. diesel taxation

Fiscal externalities across jurisdictions can arise from imperfect tax enforcement and the avoidance behavior of taxpayers. Base shifting to low tax jurisdictions tends to generate positive fiscal externalities, while understating the overall tax liability leads to negative fiscal externalities when the tax base is apportioned across jurisdictions. While much of the literature has focused on base shifting and the resulting “race-to-the-bottom” in tax rates, we examine an empirical setting illustrating how negative fiscal externalities can dominate. Truckers in the United States owe state diesel taxes based on diesel consumption, which is apportioned to states based on the miles driven in each state. We document that an increase in the tax rates of other states negatively impacts own-state taxed sales, suggesting that evasion by understating the number of gallons consumed is the predominant source of externalities, since doing so reduces the tax revenues of all states. Our estimates of the tax reaction function indicate that local tax rates respond negatively to tax rates in other states, which is in contrast to the canonical race-to-thebottom but is consistent with the sign of the estimated fiscal externalities. ∗University of California, Santa Cruz. [email protected] †University of California, Davis. [email protected]. We wish to thank Mark Phillips, Clinton Turner, and seminar participants at UCSC, Utah State, UNLV, Colby College, and the National Tax Association Annual Conference for helpful comments.