In practice, often the federal government imposes mandates on the states, which require the states to meet minimum standards of environmental quality, but without providing the funding required. This gives rise to the question as to which level of the government should pay for the cost of implementing policies. Economic literature suggests that if the level of environmental protection provided by each local government is mandated by the federal government, unfunded mandates can create a crowding out effect by forcing state and local governments to reduce non-mandates services in order to finance the mandates. An important question to be asked is whether the under-provision of public goods due to tax competition is affected by the extent to which the federal government funds the federal mandate.
To address this question, this paper uses a general equilibrium model and examines the strategic behaviors between the federal government and the state government. The results show that if the federal government funds the federal mandates through revenue raised by a federal output tax, social welfare is independent of whether the mandate is funded because an increase in federal funding does not reduce tax competition. Furthermore, the federal government has no incentive to distort its decision regarding the mandate. Thus, although the allocation of output between consumption of private and public goods is still distorted due to tax competition, the allocation of public revenue between the environmental and general public goods is efficient.
