Taxation and deadweight loss in a system of intergovernmental transfers

Intergovernmental transfer programs in many federal systems, including Canada, attempt to equalize differences in subnational jurisdictions' tax capacities on the basis of the so-called representative tax system (RTS). It is shown that RTS equalization grants effectively compensate subnational governments for a portion of the deadweight loss associated with taxes, and consequently the grants may tend to increase the distortionary tax rates chosen by subnational governments. This may be the case even when equalization is confined to tax bases that themselves are non-distortionary, such as the taxation of pure economic rents.