We have derived in Section 3.2 that decentralized tax and expenditure decisions distort the allocation if regions are constrained to finance local public goods by taxes on mobile factors. This case is commonly referred to as interregional tax competition for a mobile tax base. The literature (see e.g. Oates 1972; Wilson 1986, 1987b; Zodrow and Mieszkowski 1986a) pays great attention to this issue and emphasizes that regions respond by providing inefficiently low levels of local public goods. A sufficient instrument set to induce regions to choose an efficient allocation would include a nondistorting land tax – which is, however, not available because of institutional restrictions (e.g., it is prohibited by the German Constitution). Although an inefficient interregional tax competition can arise for the taxation of mobile households, firms, and capital, the literature concentrates almost entirely on taxing the mobile factor of production capital. Oates (1972, p. 142) describes the basic problem as follows:

The individual regions are in a “prisoner's dilemma” (see Boadway and Wildasin 1984, p. 504), since each regional government fears that capital leaves the region when it is taxed too much.