Optimal Income Taxation: An Urban Economics Perspective

Abstract

We derive an optimal labor income tax rate formula for urban models in which tax rates are determined by traditional forces plus a new term arising from urban forces: house price, migration and agglomeration effects. Based on the earnings distributions and housing costs in large and small US cities, we find that in a benchmark model (i) optimal income tax rates are U-shaped, (ii) urban forces serve to raise optimal tax rates at all income levels and (iii) adopting an optimal tax system induces agents with low skills to leave large, productive cities. While agglomeration effects enter the optimal tax formula, they play almost no quantitative role in shaping optimal labor income tax rates.

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