Article

The local distribution of endowments

matters: Modelling tax competition
with heterogeneous local residents

Urban Studies
121
Urban Studies Journal Limited 2016
Reprints and permissions:
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DOI: 10.1177/0042098016665941
usj.sagepub.com

Dae Jin Kim

University of Seoul, Korea

In Kwon Park
University of Seoul, Korea

Abstract
This study expands on the tax competition literature by incorporating the heterogeneity of
resource endowments into the tax competition framework. It theoretically elaborates that the
local distribution of resource endowments affects both the level of tax rate and the degree of
spatial dependence in tax competition, and empirically confirms the theory using the data for 60
urban municipalities in the Seoul metropolitan area (SMA), Korea in the years 20042006. A spatial panel model for tax cut confirms the presence of tax competition in the SMA and the effects
on tax cut of the resource endowment distribution. Another regression model for local indicators of spatial dependence uncovers the fact that the spatial dependence in tax cut is also determined by the local endowment distribution.
Keywords
heterogeneous endowments, spatial dependence, spatial panel model, tax cut, tax competition
Received March 2015; accepted July 2016

Introduction
Public finance scholars have long paid attention to the inter-local tax competition since
cases of tax competition were frequently
reported in Europe and the USA. Several
scholars point out the strategic traits intrinsic to the tax competition between local governments in the urban or metropolitan areas
of decentralised countries (Brueckner, 2000;
Brueckner and Saavedra, 2001; Heyndels
and Vuchelen, 1998). Applying Tiebouts
votes-by-foot to the capital movement across

the local areas, their studies develop the

inter-local reaction model where local governments make a strategic choice of tax cuts
(or not) in the consideration of their neighbours behaviours as well as the internal
conditions.

Corresponding author:
In Kwon Park, Department of Urban Administration,
University of Seoul, 163 Seoulsiripdaero, Dongdaemun-gu,
Seoul 02504, Korea.
Email: ikpark@uos.ac.kr

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Urban Studies

Since Tiebouts (1956) seminal study,

inter-local spatial correlation between local
governments is not new in public policy
studies. The literature in urban economics
and political science backs up the spatial
interdependence between subnational governments (Burbidge and Myers, 1994;
Doreian, 1980; Hernandez-Murillo 2003;
Heyndels and Vuchelen, 1998; Ladd, 1992).
While there are many theoretical studies
devoted to tax competition, only few studies
empirically verify it using relevant methodologies (Brueckner and Saavedra, 2001). The
breakthrough research on budgetary spillovers is Case et al.s (1993) study on budget
spillovers and fiscal policy interdependence.
They construct an empirical model based on
a model of interstate benefits from spillovers
that were introduced in the early theoretical
literature. Using spatial econometric techniques, they estimate strategic interaction
among state governments in the USA, where
they regard expenditures as the strategic
variable. Heyndels and Vuchelen (1998) also
construct a spatial econometric model of tax
mimicking to analyse the strategic choice of
property tax rates in Belgian municipalities.
Brueckner and Saavedra (2001) estimate a
model of strategic property-tax competition
using data for Boston metropolitan-area cities. These studies provide an empirical support for the theory that the spatial effect of
tax competition or policy mimicking exists
across local jurisdictions.
Another gap in the literature is that the
literature on tax competition does not clearly
consider the influence of local tax payers on
tax competition although the tax, regardless
of its type, is the transfer from the private
sector to the government (Borck, 2003).
Because the tax rate decision by the government determines directly tax payers net
incomes or their property values, they are
very sensitive to it and sometimes face up to
a policy which is unfavourable to their
assets.

This study aims to fill the gaps in the tax

competition literature by investigating how
tax payers utility maximising behaviours
affect the property tax rate in empirical
terms as well as in theoretical terms. We
employ the property-tax competition framework to model how local governments determine, following Brueckner and Saavedra
(2001). But the assumption of homogeneous
individuals within a jurisdiction is relaxed so
that the tax payers in a jurisdiction are heterogeneous in their endowment and income.
We incorporate this heterogeneitys influence
into the property-tax competition framework to see how the presence of heterogeneous tax payers changes the governments
strategy in property-tax competition.
A theoretical model is tested using the
data for municipalities in the Seoul
Metropolitan Area (SMA),1 Korea. In the
mid-2000s, the local governments in the
SMA competitively cut their property-tax
rates right after a property tax hike driven
by the central governments reassessment
programme. The empirical study verifies the
results of the theoretical tax competition
model with heterogeneous individuals.

Property tax competition with

heterogeneous individuals
Heterogeneous residents in tax
competition
Studies of tax competition commonly start
with a few assumptions about the factors of
production, such as mobile tax base, immobile population and a fixed total amount of
capital (Bucovetsky, 1991, 1995; Mintz and
Tulkens 1986; Wildasin, 1988a). Capital
invested in a local jurisdiction is a local governments main tax base, and capital moves
from a jurisdiction to another in response to
changes in economic conditions such as tax
rates or social infrastructure (An et al.,
2014). A typical strategic behaviour in tax

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Kim and Park

competition is that one jurisdiction takes

into account the others tax rates when it
decides its own tax rate (Wilson, 1985).
This study accepts the typical assumptions of the tax competition literature: First,
the individual residents seek to maximise the
net return from their investment in capital.
Consequently marginal returns on invested
capital across local jurisdictions will be
equalised. When the property tax is levied
on capital, the after-tax net return will also
be equal over local jurisdictions in a similar
manner (Zodrow and Mieszkowski, 1986).
Second, the metropolitan area contains
many jurisdictions, and the population in
each jurisdiction is a locally fixed labour
resource. The population produces a private
good and gets paid for labour. The private
good is directly consumed by individuals
and indirectly delivered by the local government in the form of public goods purchased
with the taxes. Third, total capital in the
metropolitan area is fixed. Then total fixed
real estate capital in the metropolitan area is
the budget constraint of the metropolitan
area. Fourth, housing is produced using
only land as in Brueckner and Saavedra
(2001). As the total quantity of land in each
jurisdiction is fixed, the supply of housing is
also fixed. The property tax of the same rate
as the capital tax is levied on housing with
appropriate choice of units for land.
Individuals are assumed to consume housing
as much as they are initially endowed.2
Given that housing consumption persists for
a relatively long time, this assumption is not
much unreasonable. These two assumptions
on the housing market guarantees market
clearance as well. In addition to this classical
setting, we introduce the condition that individuals in one jurisdiction are heterogeneous, who are identified by their different
endowments of production factors (Borck,
2003; Fuest and Huber, 2001). The typical
tax competition model assumes that all individuals within a community and across

communities have one unit of labour and

capital endowment. We relax the assumption
of homogeneity in the resource endowments
among individuals. It makes the tax competition model more realistic, contributing to the
tax competition literature. In fact, the condition of heterogeneous individuals is a key
concept for analysing the political aspect of
the tax competition because it paves a way
for linking the majority voting model to the
tax competition model (Buchanan, 1999).
While those who do not own the residential
real estate would likely vote for the redistributive policy with a high tax rate, those who
own high-priced real estate would likely vote
for a low property tax. The heterogeneous
preference for tax rates may strongly influence the tax decision making through the
pre-electoral competition.
As individuals can have more than one
resource such as labour and capital, the
modelling of the endowment distribution
will become readily complicated. Following
Borck (2003), however, one can assume that
an individuals capital endowment is negatively correlated with her labour endowment. An individual who has more labour
endowment has less capital endowment,
which is quite natural as poor residents
should work harder to make up the lack of
capital rent. Formally, an individual j in jurisdiction i provides (1 + aij ) unit of labour,
(1  aij )k  unit of capital, and (1  aij )qi unit
of land, where the mean of aij is 0 and so the
average labour, capital and land endowment
is (1,k  ,qi ). This assumption will make it
possible to handle the problem of heterogeneous endowments in the one dimension of
tax preference.

Tax rate choice in the tax competition

Given the one-dimensionality of preference,
the median voter theorem suggests that the
local government supposedly chooses the
tax rate to maximise the utility of the median

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Urban Studies

Figure 1. Illustration of the distribution of capital endowments.

voter to get the support from the majority of

its electorates (Downs, 1957). Incorporating
the distribution of endowments into the tax
competition model, we can derive the reaction
function in terms of tax rate choice in the tax
competition game. With a simple set of utility
and production functions in Tiebout tax competition model, Brueckner and Saavedra
(2001) derive the reaction function in a linear
form. Applying the median voter theorem to
the tax competition model a la Brueckner and
Saavedras, one can derive the tax rate choice
that depends on the distribution of local residents endowments.
The tax rate choice for the tax competition game is derived into a linear form as ti
= Atl + B, where ti and tl are tax rates for
jurisdictions i and l, and A and B are parameters to be determined by local variables
such as the local distribution of endowments
and the preference for public goods. For the
details of the process of derivation, see
Appendix 1. Note that these results for tax
competition between two jurisdictions can
be extended to the competition among many
jurisdictions, as the tax rate choice is a linear
function with parameters constant for each
jurisdiction. In the extended setting, jurisdiction is tax rate is expressed as a function of
a linear combination, such as a weighted
average, of its neighbours tax rates.
The linear reaction function shows that
tax rates respond to each other. The slope A

in the reaction function represents the

responsiveness of a communitys tax rate
choice to others, while the intercept B represents the level of tax rate chosen by a community regardless of the others choice. We
can see that both the slope and the intercept
depend on the local distribution of endowments and the preference for public goods.
The endowment distribution can be represented by the skewness of the capital distribution: A positive value for it means that the
proportion of residents with capital endowments smaller than the average exceeds a
half, as illustrated in Figure 1. The higher
the value, the larger is the proportion.
Consider first the intercept B in the linear
reaction function. When the marginal utility
is large enough, the intercept is increasing in
the skewness of the local capital distribution.
It implies that a community with a more
positively skewed distribution of capital
among individuals will more likely adopt a
higher tax rate regardless of the other communities tax rates. This makes sense in this
way: individuals with capital endowments
smaller than the average are the majority of
residents in that community, and under the
pre-electoral competition condition, the
political leaders of the local government will
respond strategically to the majoritys preference (Buchanan, 1999; Downs, 1957).
Individuals poorer than the average prefer
higher tax rates as they get more public

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Kim and Park

goods than they pay in the form of tax.

Thus, in a community with the majority of
residents poorer than the average, the local
government will raise the tax rate.
Consider next the slope A. We can see
that the slope, i.e. the responsiveness of a
communitys tax rate choice to others is
strictly decreasing in the skewness of the local
distribution of capital endowments. It implies
that in a community with positively skewed
distribution of capital endowments and negatively skewed distribution of labour endowments, the local government is less sensitive
to tax cut in its neighbouring communities. It
makes sense because in a community where
the distribution of capital endowments is
more positively skewed and thus the proportion of poor individuals is larger, the local
government will respond less concurrently to
other communities, i.e. less sensitive to other
jurisdictions decision making.

Hypotheses
Based on the above theoretical discussion on
tax competition with heterogeneous endowments, we can set up two hypotheses on the
relationship between the distribution of capital endowments and the local governments
choice of tax rates. As data for tax cut are
available for an empirical study, tax rate
choice is translated into tax cut choice in the
hypotheses.
H 1: Tax cut is decreasing in the skewness of
the local capital distribution, holding the other
jurisdictions tax rates.
The theory in the previous section suggests
that the tax rate is increasing in the skewness
of the local capital distribution, holding constant the other jurisdictions tax rates. A positive value of the skewness means that the
proportion of residents with capital endowments smaller than the average exceeds a
half. As the poor prefer high tax rates, the

level of tax cut should decrease with the proportion of the poor, and thus with the skewness of the local capital distribution.
H 2: The responsiveness of tax cut is decreasing in the skewness of the local capital
distribution.
The theory also suggests that a communitys
responsiveness to others in tax rate choice
depends on the skewness of the local capital
distribution. The responsiveness in tax rate
choice, specially, in tax cut decreases with
the skewness, and hence with the proportion
of residents poorer than the average. Since
poor residents prefer higher tax rates, a community where the majority of residents are
poor will be less responsive to its neighbours
tax cut.

The case of the SMA tax cut race

The Korean local government system has
two tiers under the central government: provincial governments at the higher level and
local (municipal) governments at the lower
level. A local government is governed both
by the elected official, mayor, and by the city
council. When it comes to property tax, the
central government and municipal governments have the right to decide the rates. The
central government determines the property
tax rate,3 and then local governments can
flexibly adjust the rate within a given range,
for instance, 50% of the rate, which is called
Flexible Tax Rate.
In 2004 the Korean government introduced a package of tax hikes on real estate
in order to make the tax levy more equitable. Citizens owning high priced real estate
had long enjoyed relatively low tax rates
under the old taxation system where the
assessed value of real estate was appraised
much lower than its fair market value
about 50% of the fair market value. The
revised tax act, however, raised the assessed

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Urban Studies

value of real estate almost up to the market

value, which in turn increases the property
tax burden as much.
In response to this central government
policy, some local governments started to
cut their property tax rates. Followed by
higher income earners, homeowners in the
median income group were major supporters
of the property tax cuts. These residents
opposed to the radical reassessment as they
feared that the tax hike would reduce the
value of their investments in residential real
estate. Responding to such a strong pressure
for property tax cut from their residents,
several local jurisdictions of the Seoul metropolitan area (SMA) cut their property tax
rates, which prompted the tax competition
across the metropolitan area. Of 60 urban
municipalities, 25 cut their tax rates by 10
30%. Figure 2 shows geographical distribution of the percentage of property tax cuts
for Year 2004 in the SMA.
The case of the SMA tax competition is
appropriate for an empirical test of the tax
competition model, elaborated in the previous
section. Individuals preferences for property
tax rates vary, depending on their heterogeneous endowments the values of housing.
Some municipalities have positively skewed
distribution of their residents endowments,
while others have negatively skewed distribution. As individuals preferences are translated into the local governments decision
making on tax rates, how the local endowments are distributed will determine the tax
competition game. It is expected, therefore,
that the analysis of the tax competition in the
SMA will contribute to empirically examining
the theoretical model of tax competition with
heterogeneous local residents.

Empirical methods and data

We construct two different empirical models
using the data for 60 SMA municipalities in
the years 20042006 to test the impacts of

Figure 2. Geographical distribution of tax cut for

2004.

the local endowment distribution as indicated by the theory in the previous section.
The first model aims to test the impacts on
tax rate and the presence of tax competition
as indicated in the first hypothesis H 1. It is
a spatial panel model that has the percentage
of property tax cut4 (TCUT) as the dependent variable and its spatial lag term as one
of the explanatory variables to capture tax
competition. The second one aims to test the
impact on the spatial dependence degree
as indicated in the second hypothesis H 2.
It is a classical panel model where the
spatial dependence is measured by the local
Morans I for tax cut.

The spatial panel models for tax cut

Consider first the spatial panel model for
tax cut. As Figure 2 shows, there are certain
spatial patterns in tax competition in the
SMA. The empirical model tests the possibility that local governments property tax
rate decisions are spatially dependent in

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Kim and Park

turn, whether there is strategic tax competition between local governments. To test the
existence of strategic tax competition correctly, this study employs a spatial panel
model in two different specifications.
The general model of tax competition
implies that the property tax rate is determined strategically by a local government,
considering changes in tax rates by other
local governments. At the same time, the tax
rate is determined by socioeconomic conditions specific to the local government. Then
the equation for tax rate for a jurisdiction i
at time t can be written in the first specification, a spatial autoregressive model (SAR)
as follows:
yit = a + r

n
X

wij yjt +

j=1

K
X

xitk bk + mi + vit

k =1

mi ;i:i:d:N (0, s2m ) and vit ;i:i:d:N(0, s2n )

where r is the spatial lag parameter; wij is the

weight for jurisdiction j; y is the dependent
variable; x is the explanatory variable; a is
the constant; b is the coefficient for x; m is
the individual-specific effect; v is the error
term; and s2m and s2n are variance for m and v.
Note that we are using a random effects
model, as our model introduces some timeinvariant explanatory variables. It is generally
known that a fixed effects model cannot be
used when the model includes time-invariant
explanatory variables as in this study.5
The second specification, a spatial error
model (SEM) captures the possibility that
the spatial dependence exists only in the
error term, not in the spatial lag term. It is
written as follows:
K
X

yit = a +

xitk bk + mi + eit

k =1

eit = l

n
X

wij ejt + vit

j=1

mi ;i:i:d:N (0, s2m ) and vit ;i:i:d:N (0, s2n )

where l is the spatial error parameter; e is

the spatially dependent error and v is the
normal error. Note that equation (2)
includes the spatial lag term not for the
dependent variable, but for the error term
unlike in equation (1).
If the property tax cuts in the SMA have
spatial correlation, then the weight will have
a significant coefficient (r). This means the
slope of reaction function is non-zero and
tax rates in one local jurisdiction are strategically chosen in response to tax rate changes
in other local jurisdictions.
The matrix of weights reflects adjacency
patterns among municipalities. Two kinds of
weighting schemes were used to capture different forms of capital mobility. The first
matrix, denoted by Wc, reflects a simple contiguity and so it assigns a weight of 1 to
local jurisdictions that share borders with a
given jurisdiction, and a weight of 0 to others. As a variant of Wc, the second weight
matrix Wc2 has a value 2 for the first order
neighbours and 1 for the second order neighbours based on the contiguity definition of
neighbours. Both weight matrices are then
row-standardised for ease of interpretation
as usual. We estimated the spatial panel
models using a Stata module called XSMLE
developed by Belotti et al. (2013).

Spatial dependence model

Consider next the regression model for the
relationship between spatial dependence and
the local endowment distribution. The second hypothesis H 2 indicates that the slope
of the reaction function depends on the local
endowment distribution as captured by the
parameter aim . In other words, the degree of
dependence of a municipality on its neighbours in making a decision on tax rate is
determined at least in part by the local distribution of its residents endowments.
As the local distribution varies over jurisdictions, the degree of spatial dependence

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Urban Studies

also should vary. But the spatial models

introduced in the previous section measure
the spatial dependence averaged over all
municipalities, as indicated by a constant
coefficient r. In order to measure the varying spatial dependence, we need a more
complicated model where the spatial lag
term has a varying coefficient depending on
the local endowment distribution. As it will
be very challenging to estimate such a complicated model, we adopt an indirect method
to approach the question.6
Instead of measuring the slope of the
reaction function, we investigate how the
local endowment distribution affects spatial
dependence in tax cut. As the spatial dependence should vary over space, we need a
local measure of spatial dependence rather
than the global measure. Therefore, we
introduce the local Morans I as the local
measure of spatial dependence. For a variable x in location i, the local Morans I is
defined by Anselin (1995) as follows:
N
xi  x X
wij (xj  x)
2
Si j = 1, i6j
.
P
where Si2 = Nj= 1, j6i (xj  x2 ) (N  1), x is
the mean of x, N is the total number of
regions, and wij is the (i, j) element of the
weight matrix. With two different ways of
weighting, i.e. Wc and Wc2, the indicator can
have two different values for each region.
The local Morans I represents the degree
and direction of spatial dependence for a
specific locality, while the global Morans I
does for the whole area. Its sign represents
the direction of spatial dependence and its
magnitude does the degree of spatial dependence. Spatial dependence in tax competition means that the choice of tax rate in a
community is dependent on the decision in
its neighbours. A positive value means that
the decision goes in the same direction, while
a negative value means the opposite. The

Ii =

higher the magnitude is, the higher the

degree of the dependence is.
With this local measure of spatial dependence, we introduce a classical panel model
that measures the impact on spatial dependence of the local distribution of residents
endowments.7 The dependent variable
(STDEV_I) that represents the degree of
spatial dependence in tax cut is measured by
the standard deviate of local
Morans
I,

p
Var(Ii ); see
i.e. STDEV Ii = Ii  E(Ii )
Anselin (1995) for details. Thus the model is
specified as follows:
STDEV Iit = d +

K
X

xitk g k + ui + yit

k=1

ui ;i:i:d:N (0, s2u ) and yit ;i:i:d:N (0, s2y )

where x are the explanatory variables; d and
g the regression parameters; u is the
individual-specific effect; y is the error term;
and s2u and s2y are variance for u and y. As
the model is a classical linear panel model, it
is estimated by the generalised least squares
(GLS) method.

Data and variables

We estimate the empirical models using the
data for 60 urban municipalities in the
SMA in the mid-2000s,8 excluding six rural
municipalities where residents hardly
respond to the residential real estate value
because most of area is the farmland and
pasture. While the first model uses the percentage of tax cut as the dependent variable, the second uses the local Morans I of
tax cut. Even if the dependent variables are
different in the two models, we introduce
the same set of explanatory variables
except the spatial lag terms in the spatial
econometric models.9 It is because that
equation (A-9) in Appendix 1 indicates
that the intercept and slope are determined
by a similar set of variables. The set of
explanatory variables is listed in Table 1.

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Kim and Park

Table 1. Variables and data sources.

Concept

Variable

Description

Data source

Dependent variable
Strategic Tax Policy

TCUT

Percentage of property tax cut

(for example, if a municipality
cut the tax 30%, the variable
takes the value 30)

Public announcement
by local governments

SKEW

Skewness of estimated
apartment values (Apartment
value is measured by mean
apartment price per m2 of
March multiplied by apartment
size)
Proportion of policy project
budget to gross budget in the
general account
Number of nursery facilities per
1000 children aged four years or
less
Percentage of own source
revenue (local tax receipt plus
non-tax receipt) in the gross
budget by general account
Natural logarithm per capita
local tax in the previous year
1 if the mayors political party is
conservative in the 2002 Local
Election; 0 otherwise
Natural logarithm of the average
apartment price per m2
Proportion of workers in major
industrial sectors to the
registered population
Natural logarithm of registered
population in a jurisdiction

Statistics Korea
(2005b)

Explanatory variables
Distribution of Capital
Endowment

Demand for Public

Services

PROBUD

Demand for Social

Welfare

NUM_NURS

Fiscal Independence

DEGIND

Tax Capacity

LN LAG_LT

Political Support for

Conservative

CONS_PARTY

Tax Base

LN APT_PRICE

Labour Resource

NUM_WORKERS

Population

LN POP

Data for the dependent variables were

collected directly from the public announcement of the property tax cut that each local
government made. The explanatory variables, all local level data, include the home
(apartment) sales price skewness (SKEW),
the ratio of project budget to total budget
(PROBUD), per capita local tax revenue
lagged one year (LN LAG_LT), the ratio of
own source revenue to total budget, the
index of fiscal independence (DEGIND), the
number of nursery facilities per 1000

MOGAHA (2004a,
2005a, 2006a)
MOHW (2004, 2005,
2006)
MOGAHA (2004a,
2005a, 2006a)
MOGAHA (2003,
2004a, 2005a, 2006a)
NECK (2002)
KREIA (2004, 2005,
2006)
Statistics Korea (2004,
2005a, 2006)
MOGAHA (2004b,
2005b, 2006b)

children (NUM_NURS), the number of

workers in major industrial sectors per
1000 people (NUM_WORKER), the apartment price per square metre (LN APT_
PRICE), dummy variable for the mayors
political party as of the 2002 local election
(CONS_PARTY). Tables 2 and 3 show the
descriptive statistics and bivariate correlations for these variables, respectively.
The key explanatory variable is the home
value skewness. It is used to capture the local
distribution of capital endowments, which

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Table 2. Descriptive statistics.

Variable
TCUT
SKEW
PROBUD
NUM_NURS
DEGIND
LN LAG_LT
CONS_PARTY
LN APT_PRICE
NUM_WORKERS
LN POP

Mean
overall
between
within
overall
between
within
overall
between
within
overall
between
within
overall
between
within
overall
between
within
overall
between
within
overall
between
within
overall
between
within
overall
between
within

14.56
1.023
55.80
11.55
48.37
11.90
0.867
5.394
376.9
12.68

Std. dev.

Min

Max

Observations

17.04
13.48
10.51
0.406
0.409
5.18*10-17
10.78
4.910
9.613
2.529
2.290
1.099
15.82
15.56
3.305
0.851
0.850
0.097
0.341
0.343
0
0.505
0.506
0.059
366.3
368.1
14.82
0.633
0.636
0.024

0
0
218.77
20.281
20.281
1.023
35.2
45.57
33.90
6.96
7.923
8.536
20.1
22.07
36.24
10.42
10.56
11.67
0
0
0.867
4.340
4.381
5.293
145.1
152.8
313.4
11.01
11.053
12.60

50
43.33
47.89
2.121
2.121
1.023
79.8
67.63
78.44
18.9
17.79
14.32
92.7
91.47
56.94
13.66
13.50
12.10
1
1
0.867
6.781
6.645
5.577
2762.03
2727.04
425.88
13.88
13.86
12.78

N = 180
n = 60
T=3

Note: The overall standard deviation is decomposed into the between and within components. The overall refers to the
variable xit , the between refers to 
xi , and the within refes to xit  
xi + 
x, where 
xi and 
x are the group mean and the
global mean, respectively.

determines the collective preference for the

tax rate, say, the median voters preference.
The home value skewness is calculated using
the data for the size distribution of apartments, which are of the most dominant
housing type in the SMA.10 As the tax base
for apartments used to be calculated by multiplying the standard apartment price by the
size, the home value skewness is equivalent
to the size skewness. But the size distribution
data is provided only every five years and
thus we inevitably use the data for 2005 since
it is closest to the period of study. Hence this

variable is time-invariant over the period of

years 20042006 in our modelling.
Another important explanatory variable
is DEGIND, the indicator of a local governments fiscal independence, which is defined
by the ratio of own-source revenues to total
budget.11 Since a local governments high
dependence on external resources sometimes
undermines its fiscal stability, the ownresource revenues such as local taxes are one
of the most important factors that determine
its local autonomy. It is true particularly in
the SMA tax competition, as the central

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1
20.255
20.125
20.002
0.449
0.280
20.078
0.461
0.136
0.243

1
0.076
0.185
20.124
0.073
20.060
20.357
20.046
20.197

1
0.079
20.036
0.154
0.076
20.182
20.081
20.020

1
20.326
0.058
0.248
20.299
20.187
20.087

1
0.541
20.098
0.541
0.543
0.270

1
20.156
20.042
0.426
20.293

1
0.004
20.215
0.075

1
0.296
0.200

1
20.284

11

TCUT
SKEW
PROBUD
NUM_NURS
DEGIND
LN LAG_LT
CONS_PARTY
LN APT_PRICE
NUM_WORKERS
LN POP

TCUT

Table 3. Correlation of variables.

SKEW

PROBUD

NUM_
NURS

DEGIND

LN LAG_
LT

CONS_
PARTY

LN APT_
PRICE

NUM_
WORKERS

LN POP

Kim and Park

government tried to cut the grant to prevent

property tax cut dominoes by local governments. Threfore, local governments with
weak fiscal health are less fiscally independent of the central government and will
rarely, if ever, cut the tax down (Choe, 2005;
Man, 1999).
In addition, local tax revenue per capita
(LN LAG_LT) is complementally used in
the empirical model to capture the effect of
the tax capacity of a local government. The
variable is measured for the previous year to
avoid the endogeneity problem. Local governments with higher tax capacity can afford
to cut the property tax to a greater degree
and better make up the fiscal deficit by the
tax cut and meet their fiscal needs.
The ratio of project budget to the total
budget (PROBUD) is included to take into
account the influence of local demand for
public services on local governments tax
choice. The project budget represents the
comprehensive plan for fundamental public
services such as local infrastructure services such as the road pavement and public
transportation management, water supply
and drainage system construction. It also
includes the budget for basic local social services such as construction of nursing homes
for the elderly, public education, health, and
so on. As this variable represents needs for
public services local government should
meet, a local government with a higher value
would less likely cut the property tax or cut
it to a small extent.
Also, the number of nursery facilities per
1000 children (NUM_NURS) is included as
a proxy for the demand for social welfare
services because the project budget does not
include the expense for public child care services. There is a high demand for nursery
services in metropolitan areas because a lot
of families with children need the organised
child care services and they have no other
informal options such as care by relatives
(Hofferth et al., 1991; Seo et al., 2005;

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12

Urban Studies

Swensen, 2008). As a small value for the

variable implies a high demand for public
child care, the local government faces high
pressure of building public nursery facilities
and thus will hold their property tax rate
high.
In addition, the model includes a political
variable of whether the mayors political party
was conservative12 in the the 2002 Local
Election (CONS_PARTY) to control for the
party competition in the tax hike policy. The
need for compromise between conflicting parties creates a potential roadblock in policy
adoption (Boyne, 1994; Dubois et al., 2007;
Hansen, 1983). It is, therefore, harder for a
split government to introduce a new policy
than a unified government. A tax with the
goal of redistribution is frequently controversial in the political process because it often
gives a cause for civil strife between social
classes (Lowi, 1970). The property tax hike in
2004 had the policy goal of wealth redistribution, and was initiated by the then progressive
ruling party in Korea. It is expected, therefore, that mayors of the conservative parties
may not agree on the progressive tax hike.
The model also includes variables on
labour resources and tax base. The level of
labour resources is measured by the number
of workers in major industrial sectors
(NUM_WORKER).13 Local governments
with large labour resources are less motivated to join the property tax competition
in our theoretical model; refer to the
Appendix 1. Also, since there were no local
income and local sales taxes in Korea until
2010, only the property tax base should be
taken into account rather than taxes on
income or earnings. The property tax base
of local government is measured by the average apartment price per square metre of a
local jurisdiction (LN APT_PRICE). The
apartment value may well represent the
main tax base of a local government because
apartments are a typical housing type in the
SMA (Gelezeau, 2006). Local governments

with high apartment prices will cut the property taxes to a large degree because they can
meet their fiscal demands for public services
with relatively low tax rates.

Major empirical findings

Local endowment distribution and tax cut
First, we estimated the spatial models for
tax cut to analyse the relationship between
tax cut and the local endowment distribution. Table 4 provides the results of different
spatial panel models, spatial autoregressive
model (SAR), and spatial error model
(SEM), using two contiguity matrices,
respectively. The results demonstrate that
there exists tax competition as manifested by
the highly significant values for spatial lag
parameter r and that several variables
account for a considerable amount of the
variation in local governments tax cuts.14
The AIC and BIC values indicate that the
two models are similarly appropriate,
though SAR is slightly better than SEM.
Also, r and l are both highly significant,
which justifies the use of spatial models.
The focal variable, SKEW, the skewness
of home value distribution is significant consistently in all the models. This result underpins the argument that the tax base
distribution skewed to the right may bring
more public goods or higher tax rate than
the distribution skewed to the left. Thus we
accept the first research hypothesis, H1.
Individuals heterogeneous resource endowments are a critical condition for the tax
competition, when it is a tax base.
Previous studies argue that a high grantin-aid from the superior government leads
local governments to choose a low tax rate
with less fiscal loss under tax competition
(Brueckner and Saavedra, 2001; Wildasin,
1988b). In contrast, we find that local governments with high fiscal independence
(DEGIND) choose a higher percentage of
tax cut. Even if it looks in contradiction to

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Kim and Park

13

Table 4. Tax cut model estimation results.

Model variables

SKEW
PROBUD
NUM_NURS
DEGIND
LN LAG_LT
CONS_PARTY
LN APT_PRICE
NUM_WORKERS
CONSTANT

Non-spatial

26.434y
(3.32)
20.197*
(0.088)
1.689***
(0.511)
0.287*
(0.13)
5.056*
(2.085)
26.239
(3.899)
13.43***
(3.44)
20.0107*
(0.004)
2124.4***
(33.06)

1st order contiguity (Wc)

2nd order contiguity (Wc2)

SAR

SEM

SAR

SEM

27.260*
(3.193)
20.165*
(0.084)
1.171*
(0.518)
0.239y
(0.125)
4.450*
(2.005)
25.144
(3.753)
9.497**
(3.537)
20.00796y
(0.00413)
295.41**
(33.06)
0.299**
(0.099)

26.408*
(3.155)
20.202*
(0.101)
1.197*
(0.61)
0.230y
(0.129)
5.554*
(2.194)
25.521
(3.816)
12.70***
(3.673)
20.00922*
(0.0043)
2119.2***
(34.9)

26.576*
(3.219)
20.177*
(0.0852)
1.157*
(0.556)
0.243y
(0.127)
4.850*
(2.022)
24.56
(3.863)
11.03**
(3.521)
20.00898*
(0.0042)
2108.2**
(32.94)
0.274*
(0.13)

26.181y
(3.221)
20.199*
(0.0963)
1.110y
(0.645)
0.230y
(0.13)
5.643**
(2.168)
25.017
(3.878)
13.00***
(3.604)
20.00997*
(0.0042)
2121.4***
(34.44)

l
sm
sn
N
R2
AIC
BIC
Log lik.

6.715
11.72
180
0.3923

6.488
11.07
180
0.399
1447.6
1486
2711.8

0.351**
(0.118)
6.755
11.01
180
0.391
1448.5
1486.8
2712.3

6.662
11.31
180
0.4180
1451.9
1490.2
2714

0.363*
(0.166)
6.766
11.24
180
0.392
1452.2
1490.5
2714.1

Note: SAR stands for spatial autoregressive model, and SEM for spatial error model; standard errors in parentheses;
y
p \ 0.1, *p \ 0.05, **p \ 0.01, ***p \ 0.001.

rational choice theories, the behaviour of

local governments is rational in the case of
the SMA (Choe, 2005). Tax competition in
the SMA is partly a tax resistance against
the central government property tax hike
that aims at a more progressive tax scheme.
The central government utilises a grant-inaid and designs the fiscal sanction against
the property tax cuts by local government
(Kim, 2008a, 2008b). That is, because the
central government will not complement any
local fiscal loss from the property tax cut
and may give hidden disadvantages in the

distribution of national tax resources to

local governments, the local governments
with small own source revenue cannot but
yield to the central governments property
tax hike.
Per capita local tax revenue (LN LAG_
LT), the proxy variable for fiscal health is
significant and its coefficient has a positive
sign as expected. This supports the expectation that a local jurisdictions tax capacity
has an influence on the decision making of
property tax cut. The results also support
Brueckner and Saavedras (2001) argument

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14

Urban Studies

Table 5. Local Morans I model estimation results.

1st order contiguity (Wc)

SKEW
PROBUD
NUM_NURS
DEGIND

II

III

IV

VI

20.595*
(0.263)
20.0214*
(0.008)
20.0761y
(0.042)
0.021*
(0.009)

20.558*
(0.263)
20.0218**
(0.008)
20.089n0*
(0.043)
0.0202*
(0.009)

20.670*
(0.312)
20.0263*
(0.011)
20.152**
(0.0509)
0.0259*
(0.011)

20.618*
(0.31)
20.0270*
(0.011)
20.171**
(0.0521)
0.0247*
(0.011)

20.0008*
(0.00039)
20.534**
(0.202)
9.376***
(2.612)
0.399
1.140
180
0.145

0.4
(0.317)
20.000713y
(0.0004)
20.532**
(0.201)
9.134***
(2.604)
0.390
1.140
180
0.155

20.559*
(0.268)
20.0218*
(0.00858)
20.0852y
(0.0465)
0.0215y
(0.0126)
20.0296
(0.191)
0.389
(0.33)
20.000720y
(0.00041)
20.552*
(0.244)
9.655*
(4.274)
0.416
1.113
180
0.155

20.0006
(0.00047)
20.648**
(0.24)
11.84***
(3.114)
0.298
1.495
180
0.183

0.566
(0.375)
20.0005
(0.00047)
20.643**
(0.238)
11.50***
(3.091)
0.270
1.495
180
0.194

20.618y
(0.32)
20.0276*
(0.011)
20.171**
(0.057)
0.0244
(0.015)
0.00337
(0.232)
0.567
(0.395)
20.0005
(0.00049)
20.641*
(0.294)
11.47*
(5.146)
0.363
1.436
180
0.194

LN LAG_LT
CONS_PARTY
NUM_WORKERS
LN POP
CONSTANT
su
sy
N
R2

2nd order contiguity (Wc2)

Note: Standard errors in parentheses; yp \ 0.1, *p \ 0.05, **p \ 0.01, ***p \ 0.001.

that a communitys tax rate depends on how

strong its demand for public goods is. The
budget plan for local infrastructure and
basic social services supply (PROBUD) has
a significant and negative coefficient, implying that the high demand for public goods
decreases the degree of tax cut. The number
of the nursery facilities per 1000 children
(NUM_NURS) is also significant and its
coefficient is positive as expected.
The control variable to capture the vertical party competition, CONS_PARTY, has
the negative sign and has insignificant coefficients in all the models, which does not support the existence of political competition
between the central and local governments.
This implies that the political leaders of local
governments put focus more on the economic motive of residents than their political

parties. Lastly the economic control variables to capture the tax base and the labour
resource are also significant and have positive coefficients as expected.

Local endowment distribution and spatial

dependence
Next, we estimated the panel model for the
local Morans I of tax cut using the same
data set. With two different weighting
schemes, we have two different results of
estimation, as shown in Table 5.
The focal variable, SKEW, has significantly negative coefficients in both specifications. These results are consistent with
theoretical expectation that a municipality
with the capital endowment distribution
skewed to the right will respond less

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Kim and Park

15

sensitively to its neighbouring communities.

Thus we accept the second research hypothesis, H 2.
The other explanatory variables have the
same signs as in the tax cut model except
one variable NUM_NURS. The financial
independence variable, DEGIND has significantly positive coefficients, which implies
that a financially independent municipality
is willing to participate in the tax cut
race. The two variables PROBUD and
NUM_NURS representing the demand for
public goods have the opposite signs. While
PROBUD has the same sign as in the tax cut
model as expected, NUM_NURS has the
opposite sign. It may be due to the fact that
municipalities
with
low
values
of
NUM_NURS are located within the City of
Seoul, where tax cut competition was high
in the mid-2000s. This contrast between low
values of the variable and high dependence
in tax rate can lead to the negative sign of
the coefficient of NUM_NURS.

Concluding remarks
This study investigates how the local distribution of resource endowments affects the
property tax competition among local governments. Under the heterogeneity of
endowments within a municipality, the marginal utility of public goods cannot determine the pattern of tax competition by itself,
but the combined effect of the demand for
public goods and the resource endowment
distribution determines the property tax cut.
The heterogeneity of labour and capital
endowments implies the pre-electoral competition about the property tax rate or political actions by home owners, which in turn
affects the tax competition. The theory
implies that the local distribution of resource
endowments affects not only a municipalitys decision on the tax rate, but also the
degree of spatial dependence in tax cut. The

results of empirical analysis also support

these expectations.
First, the spatial lag parameter is statistically significant and has the positive sign,
which indicates a positive spatial interdependence of the property tax rates among municipalities. This implies that positive-sum tax
competition in the SMA occurs: holding all
other things constant, if one local government cuts the tax rate, others also cut the tax
rate strategically. Also, this reaction pattern
is stronger as local jurisdictions are closer to
each other. These results confirm that the
Tiebout tax competition model among local
governments is valid in Korea as well, not
specific to the USA, for analysing the strategic tax interaction.15
Second, the local distribution of resource
endowments, as measured by skewness of
home values, affects tax rate. A municipality
with higher skewness in home values is
adopting a higher tax rate, in other words, a
lower tax cut. In that community, individuals who own low-priced homes are the
majority, and they have a strong political
will that pushes the local government to
raise or maintain the property tax. This is
consistent with the previous studies on the
tax rate choice in the pre-electoral competition (Borck, 2003; Downs, 1957; Persson
and Tabellini, 2000).
Third, the local distribution of resource
endowments also affects how much a municipality is dependent on its neighbours in making a decision on tax rate. A municipality
with higher skewness in home values is less
sensitive to its neighbouring communities,
and thus it is less likely to participate in the
tax cut race. In that community, individuals
who own low-priced homes are the majority,
and they do not push the local government
to cut its tax rate in spite of tax cut dominoes. This finding is new to the literature,
and can be an empirical evidence for the theoretical prediction of the previous studies.

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Urban Studies

Lastly, a municipality with high demand

for public goods will maintain a high tax rate
to meet the demand. The results demonstrate
that the ratio of project budget and the number of nursery facilities per 1000 children as
proxies for the demand for public goods
restricts the tax cut decision. The results of
the local Morans I analysis on the ratio of
project budget show that a high demand for
public goods reduces the degree of spatial
dependence in tax competition, implying
that the local government tends to be less
sensitive to its neighbours.
In conclusion, this study theoretically elaborates that the local distribution of resource
endowments affects both the level of tax rate
and the degree of spatial dependence in tax
competition, and empirically confirms the theory using a panel dataset for the SMA municipalities in 20042006. It extends the tax
competition literature by incorporating the
heterogeneity of resource endowments into
the tax competition framework, and reaching
a unique conclusion about the relationship
between the spatial dependence in tax cut and
the local endowment distribution.
Funding
This research received no specific grant from any
funding agency in the public, commercial, or notfor-profit sectors.

Notes
1. The SMA consists of three provinces (SeoulSi, Gyeonggi-Do, and Incheon-Si) and 66
municipalities (25 in Seoul-Si, 31 in
Gyeonggi-Do and 10 in Incheon-Si).
2. The 2005 Population and Housing Census
shows that on average, households live
about 7.7 years in their houses (Statistics
Korea, 2011). This is a relatively long period
of time, compared with the annual choice of
tax rate by local governments. This allows
us to assume that housing consumption
equals the endowment.

3. The Korean central government has strongly

intervened in the housing market to suppress
speculative demand and maintain housing
price at a reasonable range. They have introduced various measures including taxation
for this purpose; see Ha (2013) for a review
of the mode of intervention.
4. The property tax rate varies depending on
the size and value of a condominium/single
house. The larger the size and the higher the
price, the higher tax rate is levied on it.
Therefore, we use the degree of the property
tax cut which is being applied to all residential real estate tax rates.
5. The key variable, housing value skewness
(SKEW) is time-invariant over the three year
periods of study, as the data is only updated
every five years.
6. Some studies have introduced SAR models
with two different spatial lag parameters
that vary across observation groups (e.g.
private versus public institutions) within the
same equation (Elhorst and Freret, 2009;
Fell and Haynie, 2013; McMillen et al.,
2007). To our knowledge, however, no existing studies estimate spatial models with the
spatial lag parameter continuously varying
with an explanatory variable.
7. Note that the regression model introduced
above does not exactly match up to the theoretical model but just indirectly tests the
impact on the spatial dependence of the local
distribution of residents endowments.
8. The 60 jurisdictions included in the analysis
are composed of 25 municipalities (GU)
within Seoul-Si, 26 cities in Gyenggi-Do and
9 municipalities (GU) within Incheon-Si.
9. The apartment price variable (LN
APT_PRICE) has been removed from the
local Morans I model and the population
variable (LN POP) has been included
instead, because LN APT_PRICE is not significant at all in this model.
10. The 2005 Population and Housing Census
shows that the percentage of apartments is
58.2% in the SMA.
11. Fiscal data, in particular for the revenue side
data is possibly endogenous to the property
tax cut, which began in May of each year.
To mitigate the endogeneity problem, we use

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Kim and Park

12.

13.

14.

15.

17

all fiscal data released at the beginning of

the year or at the end of the previous year.
This applies to DEGIND, PROBUD, and
LN LAG_LT.
The conservative parties include the Grand
National Party and the United Liberal
Democrats.
Major industrial sectors are composed of
manufacturing business, service industry,
transportation business and wholesale and
retail industry.
The significant value for r may be generated
by the spatial lag effect of explanatory variables for neighbouring cities rather than tax
competition. To check this possibility, we
have tested the significance of a spatial
Durbin model where the spatially lagged
regressors also included in order to control
for this lag effect. But the spatial lag regressors turn out to be insignificant while the
value for r is still significant, implying that
the significance of r is indeed generated by
tax competition.
Cases of the strategic tax competition or
similar tax interactions by local governments are reported from other countries as
well: Canada (Hayashi and Boadway, 2001),
UK (Revelli, 2001), Germany (Buettner,
2001), France (Charlot and Paty, 2010) and
Belgium (Heyndels and Vuchelen, 1998).

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Appendix 1. Tax rate choice in the

tax competition
Model setting
The metropolitan area contains n jurisdictions, and that the population in jurisdiction
i denoted by Pi is a locally fixed labour
resource. The capital in the jurisdiction
denoted by Ki is combined with the labour
resource to produce a numeraire private
good with a constant-returns technology, as
indicated by the production function f (ki ),
where ki = Ki =Pi . In addition, higher tax jurisdictions lose the tax base as capital has the
economic motive to move to another jurisdiction in order to equalise its net returns,
formally ki =ti \ 0, where ti denotes capital

tax rate. The marginal product of capital

equals the net-of-tax return under Nash
equilibrium between jurisdictions. Then, the
net-of-tax return can be expressed as
f 0 (ki )  ti = s, where s is the uniform net
return of ki and s=ti \0. The wage income
wi is equal to the return to the fixed factor of
production, and can be expressed as the production minus the total return to the capital,
i.e. wi = f (ki )ki f 0 (ki ).
As the utility of a resident j living in jurisdiction i depends on her consumption of the
private good, housing and public good, the
utility function of a resident j living in jurisdictioni is written as:
U = Ui (xij , qij , zi )

A-1

where xij , qij and zi denote the private good,

housing and public good consumption,
respectively. All the individuals in the same
jurisdiction share this utility function. By
assumption, housing is produced using only
land. As the total quantity of land Li in jurisdiction i is fixed, the supply of housing is
fixed as well. The property tax of the same
rate as the capital tax, ti is levied on housing
with appropriate choice of units for land.
Let qi = Li =Pi denote the average land
endowment for individuals in jurisdiction i.
As in Brueckner and Saavedra (2001), the
average individual endowment of capital is
the same across
i.e. let the averP the regions,
P
age be k  [ ni= 1 Ki / ni= 1 Pi .

Tax rate choice

Now, under the assumption of heterogeneous individuals, the budget constraint for
a resident j of jurisdiction i on private consumption xij are rewritten as:
xij = (1 + aij )f (ki )  ki f 0 (ki )


+ (1  aij ) s  k  + ri  qi  (ri + ti )qij
where ri is the housing (land) rent and thus
ri  qi is the average return to residential land.

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20

Urban Studies

Also, the budget constraint for the local government is determined by the capital and
property tax revenues. The local governments
budget constraint on the public good zi is:
zi = ti (qi + ki )

Uiz
Uix


2aim k  s
ti + (1 + aim )k + (1  aim )qi

MRSx, z =
=

i
k  + q + ti  k
ti

A-2

A-5

The assumption that individuals consume

initially endowed housing can be formally
written as qij = (1  aij )qi . This simplifies
the individuals budget constraint as follows:

Utility and production functions are specified in the same way as Brueckner and
Saavedras (2001) Tiebout tax competition
model as in equations (A-6) and (A-7). Also,
we assume that there are only two local jurisdictions i and l as in equation (A-8).

xij = (1 + aij )f (ki )  ki f 0 (ki )



+ (1  aij ) s  k   ti  qi

A-3

Plugging equations (A-2) and (A-3) into

equation (A-1), the utility function is
expressed as:

Ui (1 + aij )f (ki )  ki f 0 (ki ) + (1  aij )


s  k   ti  qi , (1  aij )qi , ti (qi + ki )
The local government supposedly chooses
the tax rate to maximise the utility of the
median voter. Then the first order condition
of median voters utility maximisation problem gives us:

f (ki ) = a  ki 

Ui (xim , qim , zi ) = xim + ti qim + hi zi

(ki + kl )=2 = k

ki = k  +

A-8

(tj  ti )
ki
1
=
and
ti
2b
2b

Uiz
= hi
Uix

i
ki + qi + ti  k
ti

where 1  aim denotes the median voters

capital endowment ratio to the average voters capital endowment while 1 + aim
denotes the median voters labour endowment ratio.
If the unit price of the private good and
public good is one, then the above condition
should be unity. Suppose a symmetric case
that there are two jurisdictions with the same
endowments and utilities. Since k1 = k2 = k 
under the Nash Equilibrium of tax competition, MRSx, z is written as:

A-7

s
ki
1
= b
 1= 
ti
ti
2

Uiz
Uix

(1 + aim )ki  (1  aim )k   s
ti + (1 + aim )ki + (1  aim )qi

A-4

where the index m represents the median

voter. From these three assumptions, we can
derive additional three conditions.

MRSx, z =
=

b  ki2
, With a, b.0 A-6
2

Now, plugging equations (A-6), (A-7),

and (A-8) into the right side of equation (A4), and equation (A-8) into the left side of
equation (A-4), then the reaction function is
derived, which is a linear function of ti and tl
as follows.
ti =
4b(1  hi )k (1  aim  hi )q  + (1 + aim  2hi )tl
1 + aim  4hi

A-9
This can be rewritten in a simple linear form
as ti = Atl + B, where the slope A is

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Kim and Park

21

(1 + aim  2hi )=(1 + aim  4hi ) and the

intercept B is 4b(1  hi )k (1  aim  hi )q 
=(1 + aim  4hi ). The linear reaction function shows that tax rates respond to each
other. The second order condition for the
utility maximisation is hi =(1 + aim ).1=4.
This condition is identical to the condition
that the denominator of this function has
the negative sign. With this inequality, one

can see that the slope of the reaction function is strictly decreasing in aim , i.e. A=aim
\0, while the intercept in the linear reaction
function may or may not be increasing in
aim . When the marginal utility is large
enough, however, the intercept is also
increasing in aim , i.e. B=aim . 0.

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