VoxEU Column Monetary Policy

Regional tax harmonisation may lead to gains in aggregate output

Tax policy varies widely across countries and across regions within countries. This column presents evidence suggesting that in the case of the US, harmonising tax rates could lead to significant increases in aggregate economic output. EU policymakers should take note.

Countries and sub-national governments are in perennial competition to attract firms and workers. In the US, for example, 14 states cut taxes in 2014, largely to increase their attractiveness to businesses and workers (ALEC 2014). While recent studies suggest that eliminating distortions across economic units may increase aggregate economic output (across firms, as in Hsieh and Klenow 2009; or across cities, as in Albouy 2009 and Desmet and Rossi-Hansberg 2013), little is known about the aggregate effects of harmonising tax incentives across governments in fiscal unions (IGM 2015).

By how much would aggregate real GDP change if taxes were harmonised across space? Quantifying the aggregate effects of tax harmonisation requires understanding key aspects of how taxes affect local economies and how taxes in one location affect other locations. Continuing with the US example, if New Jersey lowers its corporate income tax, firms from other states may relocate to there. This inflow of firms would benefit workers in New Jersey as their income will increase. Other states, however, would see a decrease in workers and firms and the impact on the cost of living in each state would vary depending on their degree of economic integration. For example, if firms and consumers in New York have tighter trade relationships with firms in New Jersey than firms and consumers in Florida, the effect of a tax cut in New Jersey will have larger spillovers on New York than on Florida.

A credible estimate of the gains from tax harmonisation must then quantify how simultaneous tax changes in all states determine the location of firms, workers, and trade flows across states, as well as how these tax changes affect the amount of public services provided by state governments.

Measuring aggregate effects from harmonisation

In a new paper (Fajgelbaum et al. 2015), we tackle this question by developing and estimating a spatial general equilibrium model of the US economy, and then using this quantitative model to undertake counterfactuals with respect to the distribution of state taxes.

In our model, states are heterogeneous in terms of productivity, amenities, and endowments of immobile factors. Workers and firms engage in costly trade and may relocate between states, but their mobility is limited by the degree to which workers’ tastes for amenities and firms’ productivity vary across states. Additionally, state governments collect revenue from income, sales, and corporate taxes, and use it to provide public services, which may be valued by workers and impact on firm productivity. As a result, firm and worker decisions depend on taxes both in partial equilibrium and in general equilibrium through the impact of taxes on prices and public-service provision.

Our model is flexible enough to match key features of the US economy, such as the distribution of employment, wages, and GDP across states. Importantly, our approach has the advantage that we can estimate key parameters using variation in the same tax rates that we use in our counterfactual analyses. These parameters include the elasticities governing worker and firm mobility, and the weight of public services in workers’ preferences and firm productivity. Our estimation exploits the more than 300 changes in state tax rates observed between 1980 and 2010.

We engineer a tax harmonisation policy that would eliminate dispersion in taxes across states while holding aggregate tax revenue constant. Theoretically, it is ambiguous within our model whether this policy improves real income. Empirically, we find using the estimated model that this policy would lead to an increase of 0.7% in real GDP, or about $100 billion. As the revenue collected through these taxes accounts for close to 4% of US GDP, these gains are large in both absolute and relative terms.

We explore how different parametrisations and ways of conducting the tax harmonisation affect this result. We continue to find real-GDP gains if taxes are harmonised while keeping real government spending constant in each state through a system of cross-state transfers, or if preferences for public services are allowed to vary across states.

Destination versus source taxation

Our framework provides a fresh perspective on whether corporate income taxes should be apportioned based on source factors, such as payroll, or on destination factors, such as sales. In the US, apportionment of corporate income taxes has been trending toward full sales apportionment for the last 30 years – moreover, recent authors have advocated using sales as a key apportionment factor under the intuition that sales are not distorted by corporate taxes (Auerbach 2013, Zucman 2015).

An advantage of our analysis of corporate apportionment is that it accounts for trade costs and allows firms to price above marginal cost. In these more general circumstances, sales apportionment generates a novel distortion on the flows of trade across states. In turn, this distortion affects the location decisions of firms and workers through general equilibrium effects on prices. Overall, we find that these distortions may in some cases be larger than those from payroll apportionment.

A quantitative appraisal of the Laffer curve

Our quantitative framework also provides new evidence on tax policy debates. State policymakers often argue that lowering income tax rates is like a ‘shot of adrenaline to the economy’ that may, in fact, lead to increases in tax collections (e.g. Gale 2015). The economist Arthur Laffer popularised this theoretical possibility in policy circles, to the extent that it is often referred to as the ‘decreasing side of the Laffer curve’.  Of course, whether lowering income taxes leads to an increase tax revenue is an empirical matter. To assess the effects of lower income tax rates on tax revenue, one must account for the general equilibrium effects on the size of the tax base, as well as for the fact that changes in income tax rates might affect revenues from other taxes.

Our estimated general equilibrium model is therefore well suited to inform this debate. For each state, we simulated the effect of reducing the state's income tax rate by 1 percentage point. We find that, on average, this results in a decrease in tax revenue of 13.4%. This result suggests that, for the typical US state, a reduction in income tax rates is not likely to increase tax revenues.


Tax policy varies widely across countries and across regions within countries. Our results suggest that in the US case, harmonising tax rates may lead to significant increases in aggregate economic output. We believe that our framework can be applied to other institutional settings and inform current policy debates, such as that of fiscal integration in the EU.


ALEC (2014), “State Tax Cut Roundup 2014 Legislative Session”, December, available at http://www.alec.org/wp-content/uploads/2014-TaxCutRoundup.pdf.

Albouy, D (2009), “The unequal geographic burden of federal taxation”, Journal of Political Economy 117 (4): 635–667.

Auerbach, A (2013), “Capital income taxation, corporate taxation, wealth transfer taxes and consumption tax reforms”, Technical report, University of California, Berkeley.

Desmet, K and E Rossi-Hansberg (2013), “Urban accounting and welfare”, American Economic Review 103(6): 2296–2327.

Gale, W (2015), “States That Cut Taxes Do So At Their Peril”, Real Clear Markets, July 28.

Fajgelbaum, P D, E Morales, J C Suárez Serrato and O M Zidar (2015), “State Taxes and Spatial Misallocation”, NBER WP 21760

Hsieh, C-T and P J Klenow (2009), “Misallocation and manufacturing TFP in China and India”, Quarterly Journal of Economics 124(4): 1403–1448.

IGM (2015), March 24, 2015, poll of members of the IGM Economic Experts Panel of Chicago Booth.

Zucman, G (2014), “Taxing across borders: Tracking personal wealth and corporate profits”, Journal of Economic Perspectives 28(4): 121–48. 

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