A positive model of overlapping income taxation in a federation of states

Abstract

This paper develops a positive theory of overlapping income taxation in a federation of states. The analysis provides a complete characterization of the equilibrium federal and states tax rates as functions of the level of total productivity dispersion between the states. The federal rate is increasing in the level of total productivity dispersion between the states, even if the income of the decisive voter at the federal level is above the mean income. Given that the individuals' income is endogenously determined there exists a negative trade-off between the implemented federal tax rate and the resulting states' tax rates, regardless of the pre-tax income of the decisive voter at the state level. Thus, high levels of productivity dispersion between the states cause a higher than optimal federal tax rate together with low states' tax rates. It is also shown that a system of overlapping income taxation is not efficient. The resulting inefficiency might be exacerbated by the implementation of a federal matching grants program, contradicting previous results in the related normative literature.