Can State Governments Redistribute Income? Using Source-Based Capital Taxes For Income Redistribution

Two sentiments are common among economists who study state and local public finance—that source-based capital taxation by subnational governments is a bad idea, and that state governments are powerless to redistribute income. These claims are consistent with the optimal tax literature, if the state is modeled as a small open economy—as a price taker, competing for geographically mobile factors and selling products in perfectly competitive national markets. We reject this view, and contend that the actions of the state government do influence national product and factor prices. This market power gives each state government a modest ability to redistribute income among its citizens. We construct a two-region, four-good, three-factor computational general equilibrium model of an economy, and perform simulations that show that subnational source-based capital taxes have national price effects and that they can be used to modestly redistribute income.