Optimal Spatial Taxation: Are Big Cities too Small?∗

We analyze the role of optimal income taxation across different local labor markets. Should labor in large cities be taxed differently than in small cities? Because the government needs to raise revenue and under free mobility there is equalization of utility, we find that optimal income taxes are typically not equal in cities of different sizes. The optimal tax schedule depends on the level of government spending and on the concentration of housing wealth. The optimal tax schedule for the US implies higher marginal rates in big cities, but lower than what is observed. Simulating the US economy under the optimal tax schedule, there are large effects on population mobility: the fraction of population in the 5 largest cities grows by 8.0 % with 3.5 % of the country-wide population moving to bigger cities. The welfare gains however are smaller: aggregate consumption goes up by 1.53%. This is due to the fact that much of the big output gains are spent on the increased costs of housing construction in bigger cities. Aggregate consumption of housing goes down by 1.75%