Income Redistribution in a Federal System

Abstract

The question of the appropriate level of government to undertake income redistribution is receiving renewed attention from economists.' The standard argument about the issue might be summarized as follows: 1. Interstate migration of taxpayers and transfer recipients raises the cost to voters of income redistribution at the state level above the cost at the federal level. 2. Statewide redistribution confers spillover benefits to residents of other states. 3. Therefore, as compared with a national system, decentralized responsibility for income redistribution yields both less redistribution and less than the socially optimal amount of income redistribution. The purpose of this paper is only to question step 1 of the above argument; of course, readers who accept the assumptions of the standard argument may conclude that the possible weakening of step 1 of that argument reduces the likelihood that its conclusion holds. The paper argues that the cost of redistribution faced by state residents may, in fact, be lower at the state level than at the national level because their federal tax obligations fall as the state redistributes more income. Thus, part of the cost of redistribution at the state level can be exported to residents of other states. The state's federal tax bill falls when taxable incomes in the state are reduced by increased redistribution; deductibility of state taxes enhances this result but is not necessary for it. To demonstrate the proposition without adding unnecessary complication, a simple model of income redistribution is described in which governments at all levels use linear tax-transfer schedules to redistribute income. The single-government case is considered first, then two levels of government are introduced, and finally migration is allowed. It is shown that, without migration, state costs are never greater than national costs of redistribution as long as redistribution reduces total money income. When migration is allowed, the result depends on the elasticity of migration responses compared with the elasticity of labor supply responses.

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