Optimal taxation under regional inequality

Regional productivity differences provide scope for productivity-enhancing labor mobility. Redistribution reduces relocation incentives through higher taxes or lower transfers. Combining an intensive labor supply margin with an extensive, productivity-enhancing migration margin, we determine how regional inequality and labor mobility affect optimal redistribution. Simulations using the productivity differences between rural and urban regions in the US indicate that optimal marginal tax rates are reduced by several percentage points if productivity enhancing migration is taken into account. Additionally, we study optimal regionally differentiated taxation.