Equilibrium and Stratification with Local Income Taxation when Households Differ in both Preferences and Incomes

This paper presents a model of an urban area with local income taxes used to finance a local public good. Households differ in both incomes and their taste for housing. The existence of a stratified equilibrium is shown in a calibrated two-community model assuming realistic single-peaked distributions for income and housing taste. The equilibrium features stratification of households by both incomes and tastes. The high-tax community shows lower housing prices and lower public good provision than the low-tax community. The model is able to explain the substantial differences of the local income tax level and of average income across communities as e.g. observed in Switzerland. The numerical investigation suggests that taste heterogeneity reduces the distributional effects of local tax differences. Tax differences across communities decrease with increasing taste heterogeneity. The numerical investigation also suggests that the relative size of the individual jurisdictions has great impact on the equilibrium situation. The ability of the rich community to set low taxes is higher when this community is physically small. However, a tax 'h(e)aven' need not be small.