This paper considers the situation where human capital for education is accumulated by education investments of both local and a central governments and the time devoted to educate children by residents. Local governments are assumed to supply equipment and facilities and the central government is assumed to bear operating costs for education. These investments are financed by taxing labor income as a common tax base. This leads to the occurrence of vertical fiscal externality between the different levels of governments. In addition to this vertical fiscal externality, in accumulating human capital, there exist other positive externalities both within the region and across the regions. The externality within the region, so-called peer-effect, is human capital accumulation determined not only by the time spent by a resident for a child, but also the average time spent by other residents. Externality across regions is human capital accumulation in one region determined not only by the time spent by residents, including peer-effect, but also the time spent by the residents in other regions. Among these two externalities, we especially focused on the former peer-effect, and investigated how it affects the tax rates and educational investments. Based on previous literature on fiscal externalities, we compared the unitary equilibrium where the central government determines all policy measures and the decentralized equilibrium where the central government first determines policy measures and the local governments then follow.

The main results of this paper are as follows. First, the labor income tax rate and education investments by governments become higher as peer-effects become higher. Second, even in a decentralized economy, the unitary equilibrium can be duplicated when the central government is the leader.

JEL Classification:H23, H52, H71, I25, O40