LOCAL INCOME TAXATION - AN EXTERNALITY, PIGOUVIAN SOLUTION, AND PUBLIC POLICIES

Traditionally, public finance economists have suggested that the migration incentives created by taxes on income make such taxes inferior to head taxes for local governments. This paper develops this argument in a model in which the choice of tax instrument is endogenously determined by majority rule in each jurisdiction. An asymmetric income distribution and majority rule can lead a local government to choose income taxes over head taxes. Although income is exogenous in the model, taxes on income are Pareto inefficient because of mobility. The inefficiency can be thought of as an externality created by local income taxes; the Pigouvian solution thus becomes a natural corrective mechanism to recommend. Public policies such as equalizing grants and the deductibility of local taxes are compared to the Pigouvian solution