No. 2/2015:Handling amenities in income taxation: Analysis of tax distortions in a migration equilibrium model

Abstract

The tax system may have welfare costs associated with the regional allocation of resources. Nominal income taxation distorts incentives to the disadvantage of high-cost regions. The incentive problem can be addressed by real income taxation internalizing cost of living differences. Our contribution is to expand the handling of regional allocation by including amenities in a broader horizontal equitable taxation. Good amenities and high quality of life allow for lower wages in migration equilibrium and may distort the resource allocation to the disadvantage of low amenity regions. We use a large dataset of individual wages and housing prices to identify regional wage and price differences. The regional resource allocation is analyzed in a calibrated migration equilibrium model of a representative household capturing the basics of the Norwegian income tax system. Tax reform handling the two types of distortions has important and opposite quantitative effects for the resource allocation across regions when amenities and cost of living are positively correlated as in the Norwegian data.