Optimal Spatial Taxation

We analyze the role of optimal income taxation across different locations. Existing federal income tax schedules have a distortionary effect and result in the misallocation of labor across cities of different size. Because of higher productivity in big cities, wages for identically skilled workers are larger than in small cities. Progressive taxation thus implies that citizens in big cities pay higher taxes than in small cities. With mobility, utility is equalized, and the taxes are reflected in equilibrium wages and house prices. We solve for the optimal level of progressiveness. We find that the optimal level is not zero, but that it is less than what is observed in the US economy. Simulating the US economy under the optimal tax schedule, we find large effects on output and population mobility. GDP increases are in the range of 2.6–8.8%, and the fraction of population in 5 largest cities grows between 1.5–4.9%. The welfare effects however are small, 0.008–0.067%. This is due to the fact that the big output gains are lost in increased costs of living.