Income segregation from local income taxation when households differ in both preferences and incomes

Abstract

This paper presents a model of an urban area with local income taxes used to finance a local public good. Households differ in both incomes and their taste for housing. The existence of a segregated equilibrium is shown in a calibrated two-community model assuming single-peaked distributions for both income and housing taste. The equilibrium features income segregation of the population across the communities. The segregation is, however, imperfect: some rich households can be found in poor communities and vice-versa. The calibrated model is able to explain the substantial differences in local income tax levels and average incomes across communities as observed in e.g. Switzerland. The numerical investigation reveals that the ordering of community characteristics critically depends on the substitutability between the public and the private good. The numerical investigation also suggests that taste heterogeneity reduces the distributional effects of local tax differences. The numerical investigation furthermore suggests that the rich community can set lower taxes when it is small.