Tax Islands, Fiscal Equity, and Fiscal Equalization

Abstract

Equalization of the tax bases of a federal system has been approached by the economic literature from the perspectives of both equity and Abstract efficiency. These arguments for equalization have generally assumed unrestricted mobility among residents of the federalism. A third approach is considered in this paper, in which it is argued that districts within a federal system may develop as tax shelters (or tax islands or tax colonies) to reduce the tax burden of their residents. The approach employed here moves away from the more traditional models by not incorporating an assumption of unrestricted residential choice. The tax island is seen as a case of the fiscally rich successfully disassociating themselves from the fiscally poor. The formulation yields insight into the limitations and advantages of fiscal equalization policies.