Endogenous Income Distribution, Stratification and Fiscal Decentralization

Abstract

We develop a multijurisdiction model where individuals are heterogenous with respect to their productivity. The key feature of the framework is that before moving to a particular jurisdiction where the amount of local public good is determined by the median voter, individuals choose their level of effort which determines their income. Our findings suggest that the equilibrium is productivity-stratified, i.e. jurisdictions are inhabited by individuals with similar productivity. Further, the equilibrium level of effort is jurisdiction dependent. It turns out that two individuals who are close in the productivity ladder earn dramatically different incomes if they do not reside in the same jurisdiction. Third, we study the planner's problem and characterize optimal allocations. Fourth, we study the design of the tax structure that implements optimal allocations in spite of asymmetric information with respect to productivity and effort. In particular, the optimal tax structure is such that externalities generated by free mobility of individuals are internalized. Finally, we analyze a computational model and focus on the effect of fiscal decentralization on income stratification, income inequality and welfare.