Income redistribution in a Federal system of governments

Though the traditional literature in fiscal federalism argues that the Federal government should have primary responsibility for income redistribution, U.S. states are in fact actively engaged in redistribution. This paper develops a positive model of the respective roles of state and Federal governments that can rationalize this observation. Redistribution by states creates positive horizontal fiscal externalities to other states due to migration, but negative vertical fiscal externalities to the national government due to changes in reported taxable income. We forecast that states will engage in at least some redistribution, though to a lesser degree the greater are mobility relative to taxable income elasticities. The Federal government can then choose the degree of Federal redistribution to assure that the net externalities are zero. Given such policies, we then estimate the welfare weights and migration elasticities for different income groups that would generate the effective net tax schedules observed in the U.S. The parameter estimates are broadly plausible, suggesting that the model can help explain the division of responsibilities for redistribution between state and Federal governments.

► We forecast states will always engage in some redistribution, regardless of the amount of Federal redistribution. ► Forecasted state redistribution is lower the greater are migration elasticities. ► The optimal Federal response is to design the Federal tax schedule to address interstate spillovers. ► Optimal Federal tax rates are then higher the greater are migration elasticities. ► The welfare weights and migration elasticities implied by observed state and Federal net tax schedules are broadly plausible.